At first glance, these two behemoth monthly income funds — TD Monthly Income Fund and BMO Monthly Income Fund — appear to have a lot in common. But there are fundamental differences in their asset allocations, securities selection and income-distribution policies.

Although Toronto-based BMO Investment Inc. ’s BMO Monthly Income Fund’s juicy 8% distribution may have your clients salivating, we prefer TD Monthly Income Fund and its more modest payouts. With quality managers on both the equity and fixed-income sleeves and a more sustainable distribution policy, TD Monthly Income, sponsored by TD Asset Management Inc. of Toronto, scores top marks with us, and we’ve included it on our Morningstar Fund Analyst Picks List.

Taking even a cursory look at the holdings of these two funds reveals obvious differences. The TD fund has typically held higher weightings in equities, while its bond component has been far more adventurous.

Of the TD fund’s 62% equity weighting, roughly a third is in the form of income trusts. BMO Monthly Income holds less than 50% in equities, of which barely 4% is allocated to income trusts. Consequently, the average yield of the stocks and trusts in TD Monthly Income sits at 5.2%; this trumps the BMO fund’s 3.6%.

The difference in asset allocation between the two funds partly explains the wide performance gap between them.

Over the past nine years, TD Monthly Income Fund has had an average annual compound return of 10.2%, compared to a yearly average of just 6.4% for BMO Monthly Income Fund.

Although the lead equity managers — Doug Warwick and Michael Lough of TDAM for the TD fund, and Bank of Montreal subsidiary Jones Heward Investment Counsel Inc. for BMO Monthly Income — don’t share the same approach to stock selection, their quest for yield leaves them handcuffed to the financial services sector. Both funds have an almost 50% weighting in the industry. Unfortunately for clients, the global credit crunch hasn’t been kind to banks and insurance companies — even in Canada, where our financial institutions are better capitalized. As a result, both funds have suffered losses in recent months.

On the fixed-income side, the differences have been even more pronounced. The fixed-income portfolio of TD Monthly Income is run by Gregory Kocik, a TDAM portfolio manager. He is also lead manager of TD High Yield Fixed Income, another Morningstar fund analyst pick. Kocik has consistently played heavily in high-yield corporate bonds. This has provided the fund with an extra pickup in yield, differentiating it from the BMO fund. Furthermore, Kocik is supported by a fixed-income team at TDAM that we believe is one of the best in Canada. The TD fund provides access to both a great equity manager and a great bond manager.

By contrast, BMO Monthly Income’s bond portfolio has traditionally been run very conservatively. To give you an idea of how timorous the fund has been, four years ago, its average duration was microscopically low at substantially less than one year, which is more like a money market portfolio than a bond portfolio. And for most of the BMO fund’s life, the fixed-income portion has made up about half of its holdings.

But about four years ago, Mark McMahon, senior vice president and director of fixed-income at Jones Heward, replaced departing fixed-income manager Mary Jane Yule. McMahon has taken a more constructive approach, having increased the average bond duration to 5.5 years. He has also tried to capture a little extra yield by moving down the credit-quality scale.

It is also worth comparing the income distribution policies of the two funds. After all, the main investment objective of both funds is to invest in income-generating securities that pay a steady stream of income. Here again, the two funds differ dramatically.

In the case of the TD fund, each year TDAM essentially determines a reasonable amount of income to pay out, based on its outlook for the fund’s returns. Over the past five years, the income payments have ranged from 39¢ to 66¢ per unit. This translates into yields ranging from 2.7% to 3.9%.

BMO Monthly Income, by comparison, aims to pay investors 6¢ per unit per month, or 72¢ annually. Looking back, the fund hasn’t missed a payment since launching. (Although, when it first launched, it paid less than 72¢ per year.) Currently, this works out to a yield of slightly less than 8%.

@page_break@This should send up a cautionary flag because of the BMO fund’s deficit between returns and payouts.

As noted earlier, BMO Monthly Income has returned 6.4% annually for the past nine years. But the fund has been paying an income distribution of more than 7% for most of that time.

Herein lies our biggest concern with BMO Monthly Income. In order to sustain the current payout of 72¢, it must generate a return of no less than 7.9% (the annual distribution divided by the fund’s current net asset value per share).

But we don’t expect the fund will be able to generate a return that high. Let’s do some math. BMO Monthly Income is invested roughly 50/50 in stocks and bonds. Let’s assume that, net of fees, a strong manager can produce an 8% annual return from stocks over the long term and 4% from high-quality mid-term bonds.

Given the BMO fund’s asset allocation, you’d expect it to return 6% annually. (Although returns from equities over the past several years have been well into the double digits, a high single-digit number is a more realistic long-term return expectation.)

If, over time, the BMO fund produces an average annual return of less than 7.9% but continues to pay out at this level, the fund’s asset base will erode. This will lead to one of three outcomes.

Fund sponsor BMO Investments could stay the course and continue paying out more than the fund earns year after year. But this equates to giving investors their own money back, if slowly. Given that BMO gets paid on the basis of the amount of assets it has under management, it isn’t likely to want to give investors all their money back.

BMO’s second option is to cut the distribution the fund pays in order to stop the bleeding of assets. The third option is to position the portfolio more aggressively in the hope that it generate a high enough return to fund its distribution.

A distribution cut can present a big problem for a client who has come to count on receiving a set amount of money each month. And a more aggressive asset allocation could make the fund unsuitable, depending on the investor’s risk profile. IE



David O’Leary is manager of fund analysis for Morningstar Canada in Toronto.