Total return
Total return = change in price + distributions. Two funds can pay very different amounts and leave you in the same place.
| Fund | Paid out | Price | Total |
|---|---|---|---|
| Fund A | 2% | +6% | 8% |
| Fund B | 9% | −1% | 8% |
Invented numbers, before tax. Fund B feels more rewarding because the cash arrives every month. The result is the same.
What a payout can contain
Fund payouts are called distributions. One distribution can be a mix of:
- Dividends and interest the fund collected.
- Capital gains the fund realized by selling things.
- Return of capital. Part of your own investment handed back to you. It isn't income the fund earned.
Return of capital isn't a trick, and funds disclose it. But a 9% payout that is partly your own money is not a 9% return. Fund companies publish the breakdown each year, often under "distribution characteristics" or "tax breakdown".
Covered-call funds
A covered-call fund owns stocks and sells call options on them. In plain terms, it sells someone else the right to the gains above a set level, in exchange for cash today. That cash is what funds the higher payout.
Suppose a fund collects 4% a year in option income and gives up any gain above 5%:
| The stocks return | Plain fund | Covered-call fund |
|---|---|---|
| +20% | +20% | +9% |
| 0% | 0% | +4% |
| −20% | −20% | −16% |
Real funds differ a lot: many sell options on only part of what they hold, and option income changes with the market. The shape is the lesson: steadier cash, most of the downside, less of the upside.
The trade
A covered-call fund isn't free income and it isn't a scam. It's a trade: you give up part of the strong years to receive more cash in every year. Whether that suits someone depends on what they need the money to do.
Three questions for any high-yield fund
- What was its total return over five years or more, next to a plain fund holding the same stocks?
- How much of the distribution was return of capital?
- What is the MER? These funds usually cost more than plain index funds.
Do this before the next lesson
- Pick one fund you hold, or have heard about, that pays regular distributions.
- Find two numbers for the same period: its yield and its total return.
- Find the distribution breakdown and note how much, if any, was return of capital.
A fund pays a 10% yield. Over the same year its price falls 10%. Ignoring taxes, your total return is about:
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Where this comes from
- Illustrations: Planted North, invented numbers to show the mechanism; not based on any real fund
- Canadian Securities Administrators: ETF Facts, interactive sample (distributions and costs)
- Canada Revenue Agency: return of capital reduces the adjusted cost base of your units (T3 slip, box 42)