With high incomes, don’t believe your eyes

Reality

The answer is simple: they don’t. The table below shows: 1) the total income received by each fund from its investments during its most recent fiscal year; 2) the expenses of the fund; and 3) the net income of the fund, obtained by subtracting the second item from the first. The table then shows 4) the size of each fund, at the end of its fiscal year, which can be used along with its net income to calculate 5) the actual performance of the fund. To this figure is juxtaposed 6) the presumed return of the fund, in accordance with article “3 fundsâ€.

(Officially, the funds publish a statistic called income ratio it’s similar to my real yield calculation. However, since the income ratio requires data that I cannot get from public reports, I substituted my in-house version. Close enough.)

Quite a difference! Here is the reason for the discrepancy. Although these funds pay little income, they regularly make capital gains distributions, created from their net profits made while trading their portfolios. In addition, the Gabelli and Clough funds (but not, at least in recent years the Liberty fund) are improving their capital gains distributions by periodically returning investment capital.

When declaring their distributions, closed-end funds frequently combine the three varieties into a single number which they call “dividendsâ€. They are not dividends in the conventional sense of the term, i.e. portfolio income. Rather, they are dividends in a very broad sense, that is, “payments that funds make to shareholders, regardless of the source of those fundsâ€. In other words, a closed-end fund that hid its assets under a mattress, then shelled out $ 5 out of $ 100 it owned each year, could (and no doubt) claim to pay a dividend of 5%.

Nothing in particular

Author funds do not offer remarkable returns, as the term is normally defined. Funds make large distributions not because they receive large income, but rather because of accounting tricks. An S&P 500 fund could work the same way, if it were extremely tax inefficient. As you might. Buy multiple stocks, trade them often, and then withdraw the money from your profitable trades. There ! You too can profit from an impressive “yield†portfolio.

My quarrel is not with the funds themselves. Each has exceeded their Morningstar category average over the past 10 years, with Liberty’s fund also handling the additional and impressive feat of beating the S&P 500. Rather, my dispute is about the suggestion that these funds are special. They are not. These are ordinary funds that invest in the ordinary way, and achieve ordinary (albeit strong) performance.

The author’s choices will not suit his income-seeking retiree audience. Because these are fully invested equity funds, they collapse when the stock market collapses. In 2008, the better-the performance of the three funds was Liberty All-Star Growth, which fell 40.6%. The author claims that holding a portfolio made up of these three funds will make “a retiree at ease.” Surely not.

Explore another path

The question arises: if retirees cannot receive high and secure income from equity funds, can they instead do so with balanced or bond funds?

No they can’t. Unfortunately, generous income is inevitably linked to stock market performance. In addition to high-dividend-paying stocks, which naturally suffer when stocks tumble, high-income funds either hold bonds that react directly to economic downturns, such as junk bonds, or those that are indirectly sensitive, such as emerging market debt. . Either way, these funds are far too volatile for retirees to trust except as fragments of their overall portfolio.

For example, of the 157 closed-end funds that currently report over 4%, the 2008 average total return was negative at 31%. (The results are similar for conventional mutual funds.) In March 2020, when COVID-19 rocked global markets, the average return for those 157 funds was negative 14%. There was little escape. In 2008, all but five of these 157 funds suffered double-digit losses, while in March 2020 none of the funds made any profits.

In this sense, the instinct of the author was correct. He only recommended three funds in his article, which at first glance seems reckless. Retirees will surely want to place their eggs in more than three baskets. However, with funds that really pay high returns, that is, as opposed to the low-return funds the author advocated, diversification brings little benefit. Owning lots of well paying funds just means more ways to lose money when the stock market crashes.

A dangerous illusion

The article “3 Funds” makes a bold statement: a portfolio that succeeds on “dividends only– without having to touch our principal. (Emphasis is on the author.) Many investors find such promises attractive. They want to generate high income, through a portfolio that retains a relatively stable value, without ever dipping into their capital. Spending only income, while leaving capital intact, feels responsible.

Their wish is an illusion. It can’t happen. Rather than looking for a return that is not a return at all, as with funds recommended by the author, or stretching income by owning bonds that collapse with the stock market, it is best to limit their income expectations. Settle for a lower yield, then supplement that revenue if necessary by removing the assets from the portfolio. After all, this is exactly how the asset managers cited by the author have invested.

This column was originally published on Morningstar.com. About the Author: John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar’s investment research department. John is quick to point out that while Morningstar generally agrees with the opinions of the Rekenthaler Report, his opinions are his.