As we get older and move into retirement, there will come a time when we need to start drawing on our savings. One of the easier ways to do that is through “monthly income” funds that pay out a regular distribution each month. But the nature of these funds has changed, and selecting the one that’s right for you has become a lot more challenging. Here’s a look at how to find the best monthly income fund.
In the olden days, these monthly income funds were largely traditional balanced funds, investing in a diversified portfolio of high-yielding equities and fixed-income investments. Some pay out a set distribution each month, while others will pay out a variable distribution, but the amount is generally in line with the income generated by the underlying portfolio. These distributions are treated as a mix of interest income, dividends, and capital gains for tax purposes.
T-Series funds push tax liability down the road
That all started to change several years ago when a number of the mutual fund companies launched their “T-Series Funds.” In very simple terms, these funds are regular, everyday mutual funds, except for the fact they pay out a monthly distribution that is generally treated as return of capital for tax purposes. This pushes the tax liability down the road until the investor sells their units. Another interesting aspect of these types of funds is that since they aren’t relying on the underlying investments to generate the income, the payouts tend to be higher, generally ranging from 5% to 8%.
An obvious drawback to either strategy is that if the distribution payouts are too high, you run the risk of eating into your capital sooner than you might like.
High distributions don’t equal high quality
A mistake that many investors make when looking at a mutual fund is equating a high level of distributions with investment quality. While yield is definitely a key factor when evaluating an individual equity, the yield of a mutual fund is not at all indicative of investment quality. Individual fund companies can set their distributions at whatever they want, even the underlying investments if the underlying investments do not generate sufficient cash.
This makes identifying “high quality” monthly income funds considerably more challenging. In fact, over the past couple of months, I have had a number of investors and advisors approach me to help them find some decent funds that generate regular cash flow.
The search for quality income funds
To do this, I put the fund universe through a series of screens, and then did a bit more qualitative work on the shortlist to come up with my picks. My first screen looked for funds that paid a monthly distribution of at least an annualized 3%, and had outperformed their benchmark at least 50% of the time. This gave me a list of nearly 500 funds. The next step was to put them through my valuation model, which rates a number of factors including excess return, risk, and similarity to the benchmark. This gave me a much smaller list on which to do some more qualitative analysis.
Here’s what my screen yielded:
Before investing, talk to your advisor about the suitability of these funds for your income portfolio.
Courtesy Fundata Canada Inc. © 2015. Dave Paterson, CFA, is the Director of Research, Investment Funds for D.A. Paterson & Associates Inc. This article is not intended as personalized advice. Investments mentioned are not guaranteed and carry risk of loss.