JOHN KELLETT OF RBC DIVIDEND FUND
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By Levi Folk  | Thursday, May 20, 2004


The first impression I get of John Kellett is that he really enjoys his work. And you can’t begrudge his happiness unless of course your one of the other dividend fund managers that must compete against Kellett’s stellar track record behind the RBC Dividend fund.

Kellett has cranked out one of the best performing dividend funds over just about any time frame. Consider the following compound annual returns: One year, 26.4%; Three year, 10%; Five year, 11.9%; Ten year, 11.9%; Inception, 14.2%.

Returns are one thing, and risk-adjusted returns are another. Kellett has achieved one of the best risk-adjusted returns for all Canadian equity funds when taking into account that his fund is less volatile than the market. The RBC Dividend fund has a 3 year beta of less than .5 which means his fund has less than half the volatility of the S&P TSX 60. The result is one of the best all around mutual funds in Canada.

This result was not lost on the investment community. Recently, Kellett was awarded the distinction of fund manager of the year by Investment Executive, one of the preeminent industry trade publications.

What is truly impressive about this accomplishment is that the universe of Canadian dividend paying companies is small, so there is little room for a manager to differentiate himself from the competition.

Kellett does make a difference by focusing first and foremost on running a tax efficient fund.

“When we launched it eleven years ago, I had 5 million in seed money, and I was told it wouldn’t grow. It was strictly for outside the RRSP and I had to manage it accordingly,” Kellett’s explains as to why taxation was a focus from the start.

Kellett boasts that in all the years at the helm he has had only one capital gain distribution arising from a well-timed sale in the midst of the tech bubble. “We had one when BCE spun out Nortel. We sold the vast majority of the position at $75-80 dollars, and we couldn’t shelter all that,” says Kellet. “The only people who would have lost are those that sold badly. We will never be 100% tax efficient because we pay dividend.”

The capital gains in the RBC Dividend fund are sheltered through a variety of innovative strategies. He continually roles out of equity positions with substantial capital gains whenever there are unapplied losses in the fund. In doing so, Kellett is able to allow investors to avoid paying capital gains tax on profitable investments.

When there is a stock in the portfolio that Kellett can sell for a capital gain, he will often do so and buy a stock in the same sector with similar fundamentals so as to not sacrifice his investment position. However, by triggering the capital gains when the fund has unused shelter ensures that investors will not receive capital gains distributions.

Kellett is obviously an astute stock picker, but his success is owed to several strategies he pursues to minimize taxation. Kellett manufactures losses in his portfolio by purchasing short-term, high coupon bonds. “When I do that it has three positive impacts,” says Kellett who has found a market for short-term bonds that pay an unusually high coupon of 8 percent or more. In order to pay high interest, the bonds sell well above par as high as ten or twelve dollars beyond, so there is an implicit capital loss in the bond.

Kellett uses this capital loss to offset capital gains in the fund, as described above. He uses the coupon payment to create an income stream to pay his management expense ratio (MER). And he claims he is getting value because the bonds are not efficiently priced.

If his loss creating strategy sounds complicated, consider his use of Dutch Auctions. Kellett gets all excited when he describes the many successes he has had for his unitholders by participating in the occasional Dutch auction. He has astutely placed several successful bids in these auctions which corporations often use to retire capital.

In one example, Moore Corporation, Kellett explains that he walked away from the auction with a sizeable deemed dividend and useable capital loss and a substantial profit on the stock that would otherwise have counted as a capital gain. All this, and Kellett hasn’t even started talking about his stock picking strategy.

When it comes to his investment philosophy, Kellett focuses on dividend growth over yield.

“In 1979-80 I went to a conference with a lot of pension managers and academics. The academics had studies as to how you value stocks and it was so clear that it was a stream of income that is generated, the dividend discount model.” Kellett has never looked back.

The value of a company to an investor, according to Kellett is its ability to continually increase the dividend payment. Even if the current dividend yield stays constant (because the stock price is rising), the yield on the initial investment is rising because the dollar value of the dividend is rising. So Kellett does not look for high current dividend yield. He looks for high historical dividend growth.

Kellett has about 45 companies in his portfolio out of a choice of 60 or 70 stocks that pay dividends, so he has had to be very creative to achieve his winning results. He likes the banks, “the preeminent grower of dividends, an eighteen percent increase in dividends on the sub index over the last 12 months and a 12 percent per annum increase over the last 5 years,” says Kellett. He also like the fund companies referring to Bill Holland, President of CI funds as a “genius at creating value.” He rounds out his portfolio with traditional high yielding companies such as utilities and pipelines. He has never purchased an income trust for his portfolio as Royal offers other funds that do.

Kellett has carved out a niche for himself managing the RBC Dividend fund over the past eleven years. Investors are attracted to his steady hand and strong returns and have pushed the fund to the biggest in terms of assets at RBC Funds. Still, the size of the fund does not appear to have created difficulty for Kellett in maneuvering the $3.4 billion in assets in and out of the market. And given the genuine joy Kellett exudes at the helm of this fund, odds are that the best days still lie ahead for Kellett and investors in the RBC Dividend fund.

   
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