On the Money with Dynamic Funds

PARTICIPANTS

Daryl Diamond
Chief Retirement Income Strategist

Oscar Belaiche
Senior Vice President and Portfolio Manager

David De Pastena
Vice President of Portfolio Solutions

Mark Brisley: You're listening to Retirement Income the Right Way presented by On the Money with Dynamic Funds, the podcast series dedicated to changing the retirement conversation. Join us as we pull back the curtain on retirement planning.

David De Pastena: Welcome to another edition of Retirement Income the Right Way. I'm your host, David De Pastena, Vice President of Portfolio Solutions. Today we're going to dive into the world of paycheck portfolio approaches and explore how to build a sustainable retirement income into your golden years. We're joined by, Daryl Diamond, Chief Retirement Income Strategist, and former financial advisor with over 35 years of experience in serving retired clients. We're also joined by Senior Vice President and Portfolio Manager, Oscar Belaiche, a 40-year veteran in the equity income space. They'll share their insights on how to choose the right securities when building a retirement income portfolio and how to avoid the common pitfalls that cause investors to run out of money prematurely. Gentlemen, thank you for being here today.

Daryl Diamond: Thank you, David.

Oscar Belaiche: Thanks, David.

David: Oscar, I have a question for you. It's not easy to build a portfolio that sustains income for investors. When you're looking for sustainable yield from investments you want to own, what's the approach you take? Specifically, what are some of the criteria you are looking for, or what are some of the industries that are interesting to you that investors should know about?

Oscar: We start off with our overriding philosophy, which is what we call a QUARP, which is quality at a reasonable price. We like to buy quality companies that pay a dividend or a distribution that we feel is sustainable, and that's very important. We do not like companies that are cutting their dividends or distributions. That does not meet that definition. Quality companies are those with dominant industry positions, strong balance sheets, and great management teams. We run diversified portfolios that look across at a number of sectors. Now in particular, as it relates to dividend or distribution-paying securities, we find that many sectors do have dividend-paying securities, but there are some that have much less dividend-paying securities. We tend to focus in on those that do pay dividends or distributions, and those are what we generally call the FIREUM sectors to play on the apprentice, which is the financials, industrials, real estate, energy, utilities, and materials as our core investment areas.

David: What are some of the key risk metrics when you're looking at some of these companies and securities to invest in?

Oscar: Predictability of earnings, predictability of cash flow. We like to focus on cash flow because sometimes earnings may be a little obtuse. Making sure that the cash flows are real and consistent and ideally grow over time so that the dividends can grow over time or the distributions can grow over time is very important to us. Also, of course, the balance sheet is critical as well because if you have a strong balance sheet, that also defines itself as a sustainable business.

David: I'm curious, when you're building a retirement portfolio like you've done in the past, what are some of the asset classes you love that people need to consider that are not really traditional? You mentioned a few, but what are one or two and some thoughts around those?

Oscar: We do invest in what I call a cross-asset strategy where we can invest in traditional equities with the 11 GIC sectors. Then there are the alternatives, which encompass a number of securities that, even though they may trade in the public markets, are not a traditional sector investment. Examples of those would be institutional preferreds or LRCNs, which are Limited Recourse Capital Notes. Those are types of preferred shares that are generally issued by Canadian banks. We like those a lot because they have a very attractive yield. Business development companies, which are out of the United States, those are effectively mini banks that are lending businesses, and they lend to more small and medium capitalization companies. They've been taking market share from U.S. banks in the last few years. Closed-end funds, which are accumulation of different types of securities but can often trade at a discount to net asset value, so we can buy those at a discount. They also, in some cases, use some limited leverage to generate a more attractive yield. Mortgage REITs, which lend commercially to commercial real estate, have been interesting, although in the last couple of years with rising rates, that's been an area that has had some weaknesses. We think as rates stabilize now and can come down, then that's an area that's interesting into the future. We also do option strategies where we'll do put writing and we'll collect income to be able to buy securities at a better price than they're currently trading at.

David: Would it be safe to say that to be able to get a diversified income stream that investors and securities need to look outside of dividends?

Oscar: I think that it helps to be able to look at it, but it's a very specialized knowledge to be able to invest in these particular areas of the market. Unless they have the specific expertise, it is not something I would recommend an individual investor try to do.

David: Speaking as someone who's served hundreds of clients, Daryl, in thinking about risk and the things you looked at when you were choosing managers like Oscar, what were some of the criteria or what are three criteria you were looking for when you were choosing funds like Oscar's funds to build a paycheck portfolio for your clients?

Daryl: When we first started, David, to outsource, that's the word we like to use, we were firm believers in our practice that we were great at planning, we were wonderful in execution on navigating with clients through retirement, but we felt that our clients were best served and our skill sets were most complemented by outsourcing the money management responsibility, which we did. The criteria that we look for when it comes to those investment funds that would fit the profile for the paycheck portfolio strategy was really consistency in the delivery of the distribution on a regular basis, what the overall performance of the investment manager had been, and basically, the amount of experience that the individual or their team, in the case of Oscar and the people with whom he works, what their track record had been. The saying goes quite commonly that past performance is not indicative of future performance, but we were looking for consistency in the delivery of monthly income because that was our focus. At the outset, to be candid, we were first starting to shift away from what we called the cash wedge strategy to the paycheck portfolio strategy. There weren't that many offerings, certainly nowhere near what's available in the marketplace today, but with what has evolved over the last 13, 14 years, as it relates to those investment funds that distribute regularly, consistently, and reliably, you can go through a Morningstar database and just basically filter your investment search to show those investments that have regular monthly distributions. At the outset, it really hasn't changed from what it was right up to the point in time where we stopped working with our clients. We were looking for the history, the sustainability, and the competence of the people to whom we outsourced that responsibility.

David: With so many different funds on the market that investors can choose from, a lot of them having what we call return of capital. From a portfolio manager perspective, Oscar, I'm curious, how do you manage that? How do we make sure that the investors are getting the income that is sustainable without too much return of capital? What are your thoughts on that?

Oscar: The way we look at it is there are two types of portfolios that we offer. One is what we call our milk portfolio, and our milk portfolio generates the distribution from the dividends and distributions of the companies or the securities that we invest in. There is no return of capital in that type of portfolio, other than when we invest in REITs, the depreciation can be classified as return of capital. There is a component of that, but it actually has no impact on the distribution earnings that sustain that distribution. The other way we offer clients a yield is what we call milk plus, where we have elements of both distributions that are earned and capital appreciation. That return of capital ideally is coming from the capital appreciation, certainly over the long term, that's what we've been able to do, is pay out our distributions in our milk plus funds and not impair the net asset value or the investment value of the fund. That's critical, because when you get into a situation where you're returning capital and you're not making money and you're losing money, then you quickly end up in a downward spiral where your yield grows higher, but your ability to pay that yield becomes less. That's a dangerous place to be. I think what's important is to evaluate, as Daryl was saying, the sustainability of that distribution over time and the lack of impairment of net asset value as part of that review.

David: Let's talk tax a bit because no one likes to overpay in taxes. I'm really curious, in your financial planning and building paycheck portfolios and distribution portfolios, what tax implications in a non-registered type of portfolio change the way you chose your funds? How would you choose funds for a registered account versus a non-registered account if there was any difference? I'm just curious.

Daryl: For the most part, we use the same investment funds, both for registered and non-registered, and I'll take a moment and explain why. You're correct. There's a tremendous opportunity as it relates to non-registered distributions to obtain some enhanced tax efficiency. Anytime you are improving the tax efficiency of a portfolio and the delivery of income on a non-registered basis, you're improving capital preservation and consequently the sustainability of the income being paid. It just works hand in hand. The one unknown with the non-registered accounts that really doesn't have the same impact with sheltered accounts is that if you look at the history of distribution, you will see that the tax character or the tax composition, the makeup, changes from year to year. It's a bit of a moving target. You could have situations where there's a year of large capital gains being realized through management involvement and how the portfolio is being run. You could see other years where return of capital is a substantial percentage of the overall distribution just because it's being managed. Therein lies such a substantial point. It's one of the other factors that we always used to talk to clients about and say, look, you're paying a management fee to have your portfolio managed as you would with any other investment fund or basically ETF, most of them that are discretionary. In this context where we are choosing investments to mirror with our plan of using the paycheck portfolio, in addition to investment selection, which we're depending on the managers to do, maintaining the asset mix, which we're depending on the managers to do, we're also within the management fee that they are charging, expecting them to determine how to best deliver these distributions. There's a number of things going on in a paycheck portfolio fund that we would choose to employ that you don't see in, for example, a traditional mutual fund, which is perhaps just, I don't mean to simplify it, but just focusing on security selection, balance, growth, whatever the mandate may be, without the cognizant aim of delivering a specific distribution on a monthly basis. I think that's a really substantial difference, an enhanced feature that is under-discussed when it comes to money managers that are focusing on all of the things they need to do, plus delivering that regular monthly distribution.

David: I'm curious, what are your thoughts on using Series T funds? Do they have a place in the paycheck portfolio or a retired portfolio?

Daryl: We did make use to T-Series to some degree. Obviously, mostly with those people who were higher net asset holders, net worth people, higher net worth people, also those people, coincidentally, most of whom are in the same category I just described, who had higher taxable income, higher net income figures. Really, there were some very useful applications of T-Series to complement an established portfolio up to a certain level of what we believe to be taxation as it related to before and net of taxation delivery of income. The inclusion of T-Series at the higher tax brackets, in particular, served a very good purpose, especially in light of what we just discussed a minute ago, where that was the less strain we have to put on a block of capital, the more tax-efficient that it is in the delivery of a payment or a withdrawal, so to speak, the better our chances of cap preservation and the sustainability of that over time. That's a theme I know I've come back to several times. In the retirement income market, cap preservation and income sustainability not only go hand in hand, those are two factors that we needed to have in order to ensure in our mind that clients were not going to run out of income.

David: Gentlemen, I think we've learned a ton around how to really manage a paycheck portfolio, how to choose the right securities, but more importantly, how to avoid disaster. I thank you for your time today. This was a great podcast.

Oscar: Thank you, David.

Daryl: Wonderful to be with you today.

David: Thank you, gentlemen.

Mark Brisley:You've been listening to another edition of On the Money with Dynamic Funds. For more information on Dynamic and our complete lineup of actively managed funds, contact your financial advisor, or visit our website at dynamic.ca. Thanks for joining us.

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