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The pros and cons of high-yield mutual funds

From time to time I'm asked to teach seminars. This week I was approached by a local college to teach a seminar on tax-efficient income. There's no money in it for me -- but they said that they'd allow me to attend, at no cost, any other seminars they offered.

After looking at the list of other seminars, my wife, Carolyn, is now adamant that I take them up on the offer.

Here are the seminars Carolyn wants me to attend: Topic 1 -- Fundamental differences between the laundry hamper and the floor. Pictures and explanatory graphics. Topic 2 -- Toilet paper rolls: Do they grow on the holders? Roundtable discussion. Topic 3 -- Is it genetically impossible to sit quietly as she parallel parks? Driving simulation. Topic 4 -- Real men ask for directions when lost. Live testimonials. And Topic 5 -- How to fight cerebral atrophy: Remembering birthdays, anniversaries, and calling when you're going to be late. Cerebral shock therapy sessions.

Gee, my seminar topic looks a little bland in comparison to these. At any rate, let me share with you the highlights I'm thinking about teaching.
High yields

Interest rates have been low for some time now, which has meant lower income for many investors. Rates have been so low, in fact, that many Canadians have been scrambling to find any alternative investment that provides a greater cash yield than low-rate guaranteed investment certificates and similar interest-bearing investments. In response to this, a number of mutual fund companies have developed funds that boast periodic (often monthly) cash distributions as high as 9 per cent or more annually.

Does this mean that these funds are earning returns of 9 per cent annually? Not necessarily. It just means that the cash distribution paid out to you, the investor, is that high. There's a difference between cash flow, and income. Income is the amount earned on your invested capital. Cash flow, by contrast, is the amount of cash you receive from an investment. The difference is that cash flow can be made up of income earned on the investment, and/or a return of your original capital.

Is a return of your capital a bad thing? Not necessarily.
ROC benefits

A fund that offers a return of capital (ROC) to you annually will be making distributions that are tax-smart. You see, you're not taxed on an ROC.

For example, a gentleman I know invested in a fund that distributed $1,000 to him last year, but he paid tax on just $200 of that amount. The other $800 was considered to be a tax-free ROC. You should be aware that any ROC will reduce your adjusted cost base (ACB) of the investment. This will result in a greater capital gain (or smaller capital loss) when you ultimately dispose of the investment.

Since you have to reduce your ACB by any ROC, it is possible that you could end up with a negative ACB in some cases. A negative ACB will be treated as a capital gain in the year it arises.
ROC risks

Any fund that offers a high yield may be returning capital to you. And while you may appreciate the tax-efficiency of this, your unit value could drop over time. For example, if a fund earns 8 per cent annually but is paying out distributions of 9 per cent annually, the unit value of the fund is going to drop over time as capital is returned to you. Further, a fund that is forced to liquidate investments annually to meet the high payout it promises could be triggering capital gains inside the fund, to be taxed in your hands.

The bottom line? You've got to wonder whether a fund that offers a high payout annually can keep it up without causing the unit value to drop and triggering capital gains to be taxed in your hands.

I suspect that many funds will have to reduce their current distributions to maintain their unit values in the future. If a fund offers a high distribution that may seem to good to be true, it's quite possible that it will prove to be just that over time.

Finally, beware of borrowing to invest in a fund that returns capital to you where you plan to spend, but not reinvest, those distributions. The Canada Customs and Revenue Agency confirmed in a technical interpretation dated July 16, 2002 (document 2002-0142475), that when you invest borrowed money and that investment subsequently makes a distribution that is fully or partly a return of your capital, you'll lose a portion of the deductibility on any remaining interest costs if you don't reinvest that distribution.

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