Monthly Fixed Pay ETFs & Funds Are a Brain Fart!

I talk with people all the time who have an ETF or mutual fund that pays a fixed monthly amount. In most cases, they misunderstand it.

Most think they are receiving regular income—but chances are, it’s usually a brain fart.

Many investors misunderstand how these monthly pay investments work. 

From covered call ETFs and dividend funds to monthly income funds, mortgage funds, T8/T6 mutual funds, and REITs, the mechanics can be confusing—and the implications even more so.

In my latest video, podcast and blog post, you’ll learn:

• Why are monthly pay ETFs and funds a brain fart?
• How do fixed monthly pay ETFs or funds work?
• Why is a monthly distribution not part of your rate of return?
• What is the difference between a distribution and a dividend?
• Why is a monthly distribution not new money?
• Why does a monthly distribution = Selling shares?
• Why does a reinvested distribution = No distribution?
• Why do covered call funds usually have lower returns but higher tax?
• Why are monthly pay ETFs/funds a problem for retirement income?
• Why are monthly pay ETFs/funds a problem for leverage investors?
• How can we get out of the Brain Fart?
• How can you perfect monthly pay funds?
• What are self-made dividends?
• Why are self-made dividends a perfect fit for your life?

Why are monthly pay ETFs and funds a brain fart?

Fixed monthly payments are:

– Probably not all income.

– Not part of your rate of return.

– Not a dividend.

– Not new money.

– Simply withdrawing cash from your original contributions.

How do fixed monthly pay ETFs or funds work?

To understand this, you need to understand the difference between income and cash flow. Income is what you pay tax on. Cash flow is cash you receive.

Fixed monthly pay ETFs of funds are usually (but not always) invested in investments that pay income, but the income is rarely the amount of that you receive in cash. 

You receive the same cash every month, regardless of how much is taxable.

The income shows up on year-end tax slips and statements. It is the same regardless of how much cash you received.

The distribution is the cash you received, regardless of what is taxable.

If the cash distribution is more than the income, the difference is return of capital (ROC), which reduces the book value of your investment. This means you have a larger capital gain in the future when you sell.

Why is a monthly distribution not part of your rate of return?

A monthly distribution excludes the increase or decrease in the value of your investment, and it probably includes some return of capital, which is not growth or income. It is some of your invested capital returned.

Your rate of return is shown on year-end tax slips, such as T3, T5 or T5008, plus the growth in your account. 

For example:

Interest $   100

Dividends $   300

Option premiums $   100

Capital gains realized $1,500

Total Income $2,000

Capital gains unrealized $8,000

Total Gain $10,000

With an investment of $100,000, this would be a 10% rate of return.

Note the amount of any distribution is irrelevant to your rate of return.

Example with a loss:

Distribution received $10,000

Income taxable $  2,000

Decline in market value $-30,000

Your $100,000 investment is now worth $60,000. It lost $30,000 and you received $10,000 of cash. The $10,000 cash is $2,000 income and $8,000 return of your invested capital. You pay tax on the $2,000.

Note your rate of return is a large loss, even though you received a distribution.

What is the difference between a distribution and a dividend?

A distribution is the payment of income. It is not income. A distribution can include various types of income, capital gains and return of capital.

A dividend is one specific type of income paid from stocks.

Why is a monthly distribution not new money?

A monthly distribution is not income. It is the cash you receive. It might include income and might not.

If you did not receive the distribution, you would get the same tax slips and put the same income on your tax return. The only difference would be the cash you received.

The cash you received is money you invested, not profit.

Why does a monthly distribution = selling shares?

A fixed monthly distribution is paid to you whether or not there is income.

The taxable income is on your year-end tax slips whether or not you receive a distribution.

If there was no distribution, but instead you sold the same amount of the investment, you would have the same income and cash flow (except possibly a small capital gain or loss on sale).

Why does a reinvested distribution = No distribution?

If no distribution is paid, you still get the same tax slips for taxable income.

A distribution is a payment. Receiving a distribution payment and then reinvesting it is the same as not receiving it at all.

Your investment gives you cash and you give it back. If your investment just kept the cash, that is the same thing.

Why do covered call funds usually have lower returns, but higher tax?

Covered call ETFs or funds can pay a fixed monthly cash flow. They involve owning stocks and then selling an option to buy the stock from you, usually somewhat higher than today’s price.

For example, you have a stock at $100/share. You sell for $1 a call option for another investor to buy the stock from you for $110 usually within 90 days. If the stock stays below $110, you keep the stock and the $1 “premium” you received. If the stock goes above $110, the other investor buys the stock from you for $110.

If the stock goes bankrupt, you lose all your investment, except the $1 premium.

In short, you get a $1 premium, but lose the growth of your stock above $110. Your gain is capped, but not your loss.

Most investors underestimate how often stocks rise a lot in a short period of time. The stock market has historically gained more than 20% in nearly 4 of 10 years.

In general, covered call funds make less than the stock market because they miss the large gains, which happen relatively often. They are generally seen as somewhat more conservative, lower return investments that give you a regular income.

In general, they have higher tax because the premium is taxable. It may be taxed as capital gains or income, depending on details of the fund.

If the cash you received is a fixed amount, it probably will include some return of capital (ROC) in addition to the premium taxable income.

Why are monthly pay ETFS/funds a problem for retirement income?

For retirement, you need cash flow that rises with inflation, so you can maintain the same lifestyle. Fixed monthly pay ETFs or funds pay the same amount.

Seniors often complain about being on a “fixed income”. That is what fixed pay funds provide.

There are 2 types of fixed pay funds:

1. Pay the same dollar amount.

2. Pay the same percentage of your investment.

Same dollar amount is a fixed income regardless of the return of the investment. It does not rise with the cost of living and might not be sustainable.

Nearly 20 years ago, there were income funds with a fixed dollar distribution that was 12% originally. They were essentially balanced funds – highly unlikely to make 12%/year long term. 

In 2008, they lost 30% while paying out 12%, so the investment dropped over 40%. The fixed dollar distribution was then 21% of the fund, up from 12%. Of course, the fund kept dropping in value and would never recover. The distribution had to be stopped.

Same percentage is like mutual fund T8 funds. They pay a monthly distribution of 8% of the December 31 balance for the next year. The next year, the distribution is adjusted to 8% of the year-end balance. Your cash flow goes up or down every year based on the rate of return of the prior year. You would have to adjust to a different retirement cash flow every year. It probably won’t rise with inflation.

Why are monthly pay ETFs/funds a problem for leverage investors?

With borrowing to invest into fixed pay ETFs or mutual funds, your investment loan probably does not remain fully tax deductible.

The monthly payments usually include some return of capital (ROC). 

This happens if the distribution is more than the income. ROC reduces the amount of your investment loan that is tax deductible. You have to track this. This is called the “Smith/Snyder calculation”. 

If CRA audits your borrowing to invest strategy, it is up to you to support your interest deduction. CRA does not correct your number. They either approve or deny it.

How can we get out of the Brain Fart?

Focus on your investment value plus the cash flow you receive.

Without distribution, investment is $100,000.

Distribution of $8,000: Investment value $92,000 + Cash $8,000 = $100,000.

How can you perfect monthly fixed pay ETFs or funds?

Self-made distributions.

Keep all advantages. Avoid all the disadvantages.

What are self-made dividends?

Simply sell a bit of your investments: 

• Can be every month.
• You choose the amount.
• Can be automatic with some investments.
• E.g., mutual funds or portfolio managers.

Only withdraw when you need cash.

• Very tax-efficient.
• You need cash flow, not income.
• Income is taxable cash flow.

Effective Investing for “Income”

1. Invest in equities based on the maximum reliable long-term return.

Ignore distributions. Just reinvest them all.

2. Take “self-made dividends” only when you need cash flow.

You need cash flow not income. Income is taxable cash flow.

3. When saving for retirement (“accumulation”):

• Choose “self-made dividends” of zero.
• Zero cash flow needed from your investments.
• Avoid tax on distributions.

4. When you retire, start “self-made dividends” for a sustainable withdrawal amount to provide the retirement lifestyle you want.

• “Decumulation”: Probably invest the same as “accumulation”.
• You or your spouse probably have 30+ years left. It’s long term.
• “4% Rule” works if you invest 70-100% in equities.
• Low “2.5% Rule” works for bond investors.

Self-made dividends are a perfect fit for your life.

Self-made dividends are better than monthly fixed pay ETFs & funds in every way.

1. Better investment returns. (Invest for return/risk, not for income.) You get the cash flow you want while investing for the maximum reliable long-term growth.

2. You control the timing, frequency & amount of cash flow. Sell the actual amount you need when you need it, instead of having to receive a fixed monthly amount.

3. Lower tax. Only the capital gain on the cash received. Don’t have the entire investment invested for income.

4. Deferred tax until you sell. (Deferred capital gains is the lowest taxed investment income.)

5. You can diversify globally.

6. Cash flow only when you need it. (Not forced to pay tax when you don’t need the cash flow.) No cash when you don’t need any.

7. You can plan for your cash flow to rise by inflation every year. It is the perfect fit or a long-term cash flow to maintain your lifestyle.

Ed