Yields too high to be true

Investment marketing promotes nonsense much of the time. One major component of this surrounds expected income withdrawal rates and return expectations. Advisors or managers routinely promise too much and ill-informed or wilfully blind clients buy in, usually to their financial and emotional detriment, often repeatedly. I talked about this issue in Juggling Dynamite (chapter 3: The truth about asset allocations and return expectations).

I was discussing the topic with an engineer friend a few months ago. She runs a commercial construction company. “Its the same in the construction business” she told me, “the con artists and shoddy builders under-cut our quotes with ridiculous numbers to get the job. In the end they often go way over budget, miss their targets or blow up completely. Some of them even get arrested for fraud. Meanwhile us reputable firms who won’t lie, who deliver what we promise, miss out on good clients because we quote it honestly”.

It is a mathematical fact that properly managed for capital preservation, investors today should not try to withdraw more than 3-4% a year maximum from their portfolios unless they intend to consume capital each year in doing so. I tell this to people looking for financial guidance every week. Some understand the math, accept the facts and structure their plans accordingly.  Some do not.  Some go up the street to the broker/planner/banker/investment seller who assures them that they can withdraw 6, 8, 10%+ a year, “no problem” they say, “how much would you like, we’ll arrange to send it monthly to your bank account.” As time goes on, this plan is eventually revealed as capital-consuming (even devastating) but often the clients are surprised and mystified as to why their savings are faltering so badly.

This article from the Jon Heinzl at The Globe is insightful on point:

“Monthly income funds are a hit with investors, and it’s easy to see why: They provide a one-stop solution for folks seeking diversification, low fees and – most important – a juicy income stream.

No wonder Canadians have parked more than $25-billion in the Big Five banks’ monthly income funds, some of which sport yields that are higher – in some cases a lot higher – than they can get from individual stocks or bonds.

But here’s something they may not realize: In some cases, the reason yields are so high is that the funds are paying investors with their own money.

Let’s look at an example. The BMO Monthly Income Fund pays a fixed monthly distribution of 6 cents a unit, or 72 cents annually. Based on the fund’s Oct. 17 price of $7.57, that implies a yield of about 9.5 per cent.

Sounds pretty good – until you consider that the fund posted an average return of just 3.1 per cent for the five years ended Sept. 30. A skeptical investor might well ask how the fund can afford to pay such a hefty distribution. Answer: By giving investors their own money back.”

Read the whole article:  When fund yields are too good to be true. (hat tip Howie)

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