Mutual funds question: “You need to spend money to generate income that’s sustainable, because if you don’t, then you end up eroding your capital,”

Question

From the very end of an article on CNBC:

Cox suggested investing in actively managed funds only when investors seek dividend income during retirement. “You need to spend money to generate income that’s sustainable, because if you don’t, then you end up eroding your capital,” Cox said. “So it’s worth paying for active management and worth paying for mutual funds at that point to diversify the risk of loss, but not until.”

My questions:

1. Do mutual funds pay dividends? And if they do, what's superior about mutual funds dividends compared to normal stock dividends?

2. Why would I need to spend money to generate sustainable income? Doesn't that sound stupid? And if I decided to not invest anymore in a mutual fund, I'll lose money? So how is mutual funds a good idea, particularly in retirement?

As you can see I'm not really understanding his point about buying mutual funds in retirement.

Answer 1

TL;DR: Either Cox or the reporter or the editor misspoke, misquoted, quoted out of context, or just plain misunderstood.

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The quote as it stands strikes me as nonsense. You need to produce sufficient income and/or growth to avoid drawing down capital. That doesn't require "spending" more, just sufficient savings and sufficient returns.

I would argue that you generally shouldn't pay for actively managed funds, period. There's plenty of evidence that they don't make enough more than a decent mix of index funds to make up for their order(s)-of-magnitude higher fees.

You may want a different mix of funds in retirement, less risk at the cost of less growth potential, since your timeline has shortened. And a very-low-risk emergency fund becomes more important since you may not have salary to fall back on. But that's standard investment planning, and doesn't necessarily require paying an "advisor tax" unless you feel you are not or will not be competent to handle your own finances -- and in that case you may want to have someone looking at the whole picture, not just your investments in one fund.

Also, ideally your planning should be to live out your expected (or optimistic) lifespan in what you consider comfort with enough left at the end to carry the few years of intensive care you may need plus whatever you explicitly want to leave as a legacy. If you do better, great; bonus points if you're keeping score that way. If you can't leave a legacy, Oh Well; if you don't leave a debt you've still won the game.

Oh. re mutual funds: a standard way to reduce risk (at some cost in reducing gain) is to broadly diversify your investments. Mutual funds can be a good way of doing that. I strongly disagree with "not before", though; as noted above, a pretty simple mix of index funds can perform quite well, if your expectations are reasonable and you don't panic easily.

Answer 2

Do mutual funds pay dividends? And if they do, what's superior about mutual funds dividends compared to normal stock dividends?

Mutual funds distribute dividends that the stocks they hold pay (for equity funds) and capital gains that are obtained from buying/selling stocks.

There's nothing "superior" about them. they reduce the value of the fund just like they do for stocks. If a fund distributes $1 per unit, the price of the fund goes down by $1 per unit.

Why would I need to spend money to generate sustainable income? Doesn't that sound stupid? And if I decided to not invest anymore in a mutual fund, I'll lose money? So how is mutual funds a good idea, particularly in retirement?

(The article is behind a paywall, so I'm guessing somewhat at the context)

You don't need to pay high fees to get dividend income, but you might get more dividend income with active funds that target higher dividend stocks. Whether the extra income (which is offset by a decrease in fund value) is worth the extra fee is debatable.

I think his point here is that you should not pay more for higher-dividend funds before retirement because dividends are purely for cash flow. They do not add any value (the value of the fund goes down by the amount of the dividend) and are purely to obtain cash flow without having to sell shares.

I disagree slightly that you should may more, because you can find high-dividend, low-cost funds, and can actively manage cash flow without requiring high dividend funds. I think the point is more that it's not worth paying more just to get higher dividends when you aren't getting that cash out anyway.

Answer 3

The focus on dividend-paying stocks in retirement has always seemed strange to me. You need return to fund your spending. If that return comes as dividends or interest on bonds, that is fine. If that return comes as capital gains, you need to sell some shares to have the cash you want to spend. However, that isn't as different from dividends as people make out. Dividends reduce the value of your shares as they are paid. If you look at the value of your shares, you have withdrawn the dividend. If you need to sell some shares you reduce the value of the shares you own. Aside from taxes, they are the same. You need the stocks you own to increase in value enough to compensate from the reduction caused by sales or dividends.

If you are wedded to dividend-paying stocks so that your number of shares doesn't go down you may need to invest in a managed fund unless you are aware of an unmanaged fund that invests in only dividend paying stocks. You can view the fees charged as paying for your peace of mind and it may be worth it to you.

Answer 4

TL;DR: Active Funds cost money in fees, but can be set up to produce more dividends, so they might be preferred for retirees.

Longer version below.

Active vs Index

Mutual Funds can be broadly categorized as Actively Managed Funds or Indexed Funds.

In an Actively Managed Fund, a human being is making decisions about which stocks to purchase and sell, whereas an in Index Fund some kind of algorithm is used (eg, maintain a portfolio that is representative of the S&P 500.)

Perhaps counterintuitively, the performance of Active and Index Funds, on average, is very similar. But Active Funds have higher fees, because they need to pay the person doing the trading. This means that for many cases, it makes better sense to use an Index Fund, where the performance is basically the same, but the fees are lower.

Spend Money to Generate Income

I think what the quote is trying to say is that when you approach retirement, it may make sense to "spend money" in the form of the higher fees for an Actively Managed Fund, because you can control the dividends. To get an income stream for retirement, you either need to sell some of your shares, or have dividends. Retirees generally try to avoid selling shares, since they are a finite resource (you'd need more money to buy new shares, but can only get more money in your retirement from selling shares or dividends!)

As an example, Tesla hasn't ever generated a dividend, but is a valuable company and is in the S&P 500. Therefore, an Index Fund that naively matches the S&P 500 won't be producing any dividends from the "Tesla" portion of its investment.

So you might pay more in fees to have a Managed Fund that with the goal of "matching the S&P 500, but with a bias towards dividend producing stocks."

This Fund would have similar performance to the Index Fund, but produce more dividends for your to use on expenses.

Answer 5

It sounds an awful lot like someone trying to justify his salary (based on your quote, as the rest of the context is only available to subscribers)

Mutual funds distribute to you the dividends they receive from their portfolio.

Now it might make sense to internally reinvest some of those dividends instead of paying them out so that the principal can be bolstered to keep up with inflation, but it is not the role of an active manager in a mutual fund to do that. Even if you were to assume he knew how to do that appropriately, he is not allowed to. The fund is legally required to distribute to you the dividends that it receives.

What a good mutual fund manager could do is choose stocks which internally reinvest much of their profits (rather than paying all of them out as dividends) over hypothetical stocks that overreach and end up sacrificing future growth for the sake of excessive current dividend payouts. Whether the fund manager has the incentives and skills to do that effectively is doubtful, but at least it is a sensible goal.

If you want to pay someone to tell you "Don't focus on dividend payout to the exclusion of growth, otherwise your future dividends won't keep up with inflation or will even fall outright as the under-capitalized companies do poorly", it would probably do better to pay a financial planner to tell you that rather than an mutual fund manager. But you can also get that advice for free.