T class funds
Tax efficiency myth and structural risks
It has long been known that investors would rather invest in something that distributes a regular amount of cash rather than sell their shares to generate cash flow. This psychological phenomenon seems to hold no matter what the source of cash distributions. Add perceived tax-friendliness and it's no wonder that T class mutual fund units are so popular. But the mirage of T class funds' tax efficiency comes with unique challenges.
T class fund example
T class is short for 'Tax' class - so called because of the perceived tax advantage. The appeal of a T class fund lies in its relatively high and level cash distribution. The tax moniker is given because the majority of the monthly cash payout is not taxable when received. Instead, it's classified as 'return of capital' for tax purposes.
To illustrate, compare Mackenzie Cundill Global Balanced C and Mackenzie Global Balanced T8. The C and T8 labels denote separate classes of units of the same fund. The C units pay out only the amount of distributions required to avoid tax at the fund level. The T8 units pay out an even amount of monthly cash. (The number eight in T8 denotes a distribution rate of eight percent based on the unit price at the time the units were launched.)
For the year ending June 30, 2007, the C units paid out $0.06 per unit, or about 0.8% of net asset value. During the same period, the T8 units paid out $1.08 to unitholders, or about 8.5% of net asset value. Recall that these are different unit classes of the identical mutual fund trust. So how is it that one class pays out more than ten times the distribution of the other class?
Income wasn't created out of thin air. Instead, Mackenzie simply set the T8 units' distribution at a high level - well in excess of the actual income generated in the fund. The difference between the distribution and the actual amount of taxable income (net of fees) is classified as 'return of capital'.
To the extent that a fund's distribution exceeds a fund's total return, the fund's unit price will fall. Indeed, the November 30, 2007 unit price of Mackenzie Cundill Global Balanced fund's T8 units is 6.3% lower than it was exactly a year before, despite a 1.7% total return. It's no coincidence that the 1.7% total return minus the 6.3% fall in price equals the T8 units' 8.5% distribution rate noted above. Similarly, the fund's C series units rose in price by 0.9% over the past year. Add to that the 0.8% distribution rate and you have the fund's same 1.7% total return.
The key is understanding the source of this cash distribution.
There are four possible sources of a fund's regular cash distribution.
1. A fund that brings in more money from new and existing investors than it pays out to selling unitholders will be able to take some of the 'net inflows' and pay it out to cover monthly distributions.
2. In the absence of 'net inflows', a fund may hold elevated cash reserves to fund monthly cash payouts.
3. A fully invested fund that has no significant 'net inflows' can instead sell some of its investments to fund monthly cash distributions.
4. Finally, fund's last resort source of cash is a line of credit that can be tapped to keep the cash flowing.
In short, investors in a T class fund that is not experiencing strong 'net inflows' may end up paying more just to keep the cash flowing out to yield-hungry unitholders. This extra cost could come in the form of cash drag (in the case of point #2 above), extra taxes (see point #3), or interest costs (see point #4). Indeed, the T8 units of the above Mackenzie fund had about double the percentage of taxable income as the C units (1.6% of net assets vs. 0.8%) for the year ended June 30, 2007.
Fans of T class funds often point to the supposed tax benefits of T class distributions. But that's like highlighting that it's cold during winter. And as noted above, in some cases the taxable amount of distributions can be higher with T class funds.
T class distributions are tax efficient because the distributions are made up of a combination of your original capital (i.e. hence the falling unit price), unrealized growth, and (to a lesser extent) realized taxable income. Generally, only the latter is taxed year to year.
T class funds have been described as 'internal systematic withdrawal' mechanisms. Accordingly, I prefer to see investors determine the precise amount needed, and withdraw it monthly by selling units of a fund to produce roughly the same after-tax cash flow as T class funds. The precise strategy depends on an investor's needs and circumstances but I have never recommended T class funds to fund cash flow needs.
Finally, those taking a T class fund's distribution in cash (and spending it) had better check to see if the distribution is sustainable. There have been many examples of funds paying out unsustainable amounts. IA Clarington Canadian Income (2001) and IA Clarington Monthly Income (spring 2006) are two such examples I've identified in the past.
In my opinion, each of these funds remains in danger of either cutting their distributions or further eroding the respective unit prices. And they're not alone, so a distribution reality check is a must for any investor making use of such funds and taking the distribution in cash.
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 firstname.lastname@example.org
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