For investors that own a monthly income fund of some kind, Dan Hallett’s article in the Report on Business today is a must read (How to test Whether Cash Payouts Will Still be There Tomorrow).

As Dan says, “the industry has created numerous products that kick out generous amounts of cash each month.” But many of these funds can’t sustain their distributions without being forced to return capital to the unitholders (their own capital).

Dan calculates the return that’s required for the BMO Monthly Income Fund to sustain its 6 cent per month distribution.

• After factoring in costs (the MER is 1.51%), the fund needs to generate a pre-fee return of 10.5% per year.
• He assumes that the bond portion of the fund (50%) will earn 3.7%, therefore contributing 1.9% to the total return (3.7% x 50%).
• Dan then works backwards to determine what stock returns need to be. That number is 17%.

Needless to say, in a 3% interest rate world, 17% is a pretty high expectation. In any world for that matter.

With the low-risk portion of these funds earning so little today, I’m sure many or most of them will be forced to do one of two things: continue to have the investors take back their money to support the distributions (which means the fund price will decline over time), or reduce the payouts.

The lesson here is that we shouldn’t treat these funds as if they’re a GIC or other fixed income security. They’re perfectly good balanced funds (assuming the fee is reasonable) that will generate returns of 4-7% over the long term. They’re different from traditional balanced funds, however, in that they’re paying out the earnings in advance. It’s kind of how the western world is running its economy – spend now and pay later.