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What makes Mackenzie Managed Yield Class tick?
Popping the hood on tax-efficient Mackenzie fund

Mackenzie Financial Corporation is perhaps the most innovative mutual fund company in Canada. From the introduction to deferred sales charge (DSC) commissions, to the new breed of RRSP clone funds, to the wave of multi-manager funds, Mackenzie has always been a leader in product innovation. When they announced the launch of their tax-deferred corporate class funds, they also unveiled an innovative twist on money market offerings. The Mackenzie Canadian Managed Yield Class and U.S. Managed Yield Class funds are structured to provide returns like a money market fund, but with the tax advantages of capital gains.

The new offering

In June of this year, I explained how the tax-deferred corporate class funds work and how they can defer taxes and minimize distributions. I won't repeat the details here, so if you need a refresher, click here. While Mackenzie's launch of this type of structure was nothing new, there was an innovation to be found in the new offering - the Managed Yield Classes. Essentially, these new funds were structured so that investors could be assured of a money market return with the tax benefits of capital gains, fifty per cent of which are taxable. Instead of monthly interest distributions, these funds pay out monthly capital gains distributions. The result: returns like a money market fund, without the tax headache of fully taxable interest. How do they do it?

Structure and distributions

If you check out the composition of the funds on Mackenzie's website, you'll notice that, for instance, the Mackenzie Canadian Managed Yield Class is nearly fully invested in Canadian stocks. Recall however that the fund generates a money-market-like return. To accomplish this task, the funds use customized derivative instruments. Mackenzie uses the word "options" in much of their literature (and in the prospectus) but they appear to really be using a derivative instrument known as a swap. Remember that futures contracts and options are standardized contracts and, as a result, trade on an organized exchange. However, swaps are customized for each situation and, as a result, are privately arranged rather than traded on an exchange. Let's use the Canadian Managed Yield Class to illustrate how this works.

As we already know, this fund will buy a portfolio of Canadian stocks but it wants to generate money market returns. The bank, on the other hand, may have a portfolio of money market instruments but it may want to get exposure to stocks without going through all of the transactions of doing so. So, the Canadian Managed Yield Class has stocks but wants money market returns. The bank has money market instruments but wants stock returns. The terms of the swap agreement allow each party to get what it wants. The swap will say something like "the fund will pay the bank the return on its stocks and the bank will pay the fund the return on its money market instruments". A net cash payment is made quarterly to settle the contract, depending on the stock and money market returns. Let's say, after the first quarter, the fund's stocks gained two per cent, while the bank's money market instruments gained one per cent.

The fund's return for that quarter is made up of:

  • the gain of two per cent on the stocks it holds;
  • minus: the same two per cent stock gains that it must pay the bank under the swap;
  • plus: the one per cent gain on the money market instruments that the bank must pay to the fund.
  • Net return = the money market return

    The bank's net return will be equal to the stock portfolio's return. What the bank actually pays to the fund is a rate based on Bankers Acceptance - a corporate debt obligation backed by the bank. The US Managed Yield Class works the same way (using Canadian stocks), except that the bank will pay the fund a rate equal to U.S. LIBOR - a reference rate of interest at which three-month U.S. dollar deposits are offered to prime international banks. Both BA and LIBOR rates are similar to money market instruments (i.e. treasury bills or short-term government bonds).

    Payments under a swap agreement are treated as regular income for tax purposes. However, because these funds are two of the many classes that make up Mackenzie's tax-deferred capital class structure, this income is used to pay expenses of the Managed Yield Class funds, in addition to those of other classes. Capital gains resulting from other classes are flowed through to the Managed Yield Classes in the amount of the net return. The result: money market returns paid out monthly in the form of capital gains.

    Risk

    The main risk with this structure is credit risk. If, for instance, the bank with which it enters into the swap agreement (i.e. the counterparty) falls on hard times, it may be unable to make good on its payment to the fund. This credit risk is small since the fund will be dealing only with the largest and strongest of Canada's banks, but it's a risk that doesn't exist with regular money market funds.

    Costs

    The management fee is 1.25%. Operating expenses should run between 0.30% and 0.50%, for a total MER of 1.66% to 1.87% per year, including GST. Since the use of swaps is similar to that used in clone funds, the costs of this structure should run about the same - 0.50% annually. Since this is a transaction fee (like trading fees for stocks), it won't show up in the MER.

    Recommendation

    While Mackenzie deserves credit for its mutual fund innovation, it seems like a lot of trouble go through just to produce money market returns. After all, regular money market funds in tax-deferred corporate class structures from companies like AIC Funds, CI Funds, and others, go a step further without the complexity of swaps. The interest is "eaten up" by expenses but usually no distributions are paid. Instead, the unit price creeps up slowly each month. When you sell, you realize a capital gain, rather than having it paid every month.

    Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
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