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Smarter CEF Investing in 2012 Starts With a DRIP

In response to many readers' questions about DRIPs, this week we examine the ins and outs of investing in a CEF's DRIP. 

Cara Esser, 02/03/2012

Since my colleague, Morningstar analyst Mike Taggart, mentioned Dividend Reinvestment Plans, or DRIPs, prominently in an article back in December, many readers have written in for advice on how DRIPs work and how investors can participate in them. A DRIP allows current investors to reinvest their fund's distributions at an advantageous price instead of receiving cash. These programs are offered by most closed-end funds, or CEFs. (Only 15 CEFs do not currently offer DRIPs.) We believe that reinvesting distributions and taking advantage of the price deals can, over time, significantly benefit long-term investors' returns. In fact, we had assumed that many CEF investors partook of this benefit of ownership.

Because of the number of inquiries we received after the article, we made a few calls. Imagine our surprise when we learned from speaking with numerous fund executives that most investors do not take advantage of these programs. In fact, one large fund company told us that the number of DRIP participants in most of their funds is in the low single digits.

Before we discuss the low participation rate, we will take a closer look at the mechanics of a CEF's DRIP. Because DRIPs can vary vastly from fund to fund, we need to make some generalities based on common practices. Every fund is different. This discussion is meant to provide a high level overview of how a DRIP works, not to give specific advice or information about a single fund's plan.

DRIP Basics
If you are curious about what your fund's DRIP program is like, the place to start is with the annual report, where you'll find information about the plan. If you can't find information there, you may find a DRIP prospectus or similar document on the fund's website. Most DRIPs are run by a plan agent or plan distributor that handles the administrative details and paperwork for a fund's DRIP. Any questions or concerns about the plans are generally addressed directly to the plan agent. While plan features differ greatly across fund families, there are also differences across funds in a single fund family. BlackRock, for example, uses two different plan administrators for its DRIPs, and each plan administrator has a different fee schedule for buying and selling shares. In addition, some funds allow investors to participate in the DRIP for some--but not all--of the shares owned, while others require full participation. If you choose to contact the fund or the plan agent about the DRIP, they will send copies of these documents to you.

Most DRIPs require participants to be shareholders of record. Whether you realize it or not, when you purchase shares of most exchange-traded securities, including CEFs, the shares are not held in your name. The shares are typically registered in your broker's name, known in the industry as "street" name. If you decide to invest in your CEF's DRIP, the first order of business is to contact your broker or advisor to inquire how you can reregister your CEF shares in your name or how you can become the shareholder of record. Be aware that, depending on your broker, you might meet some mild resistance. However, this is typically a fairly straightforward process that does not require a lot of paperwork.

Once you are the shareholder of record, it is important to note that most DRIPs are "opt in," which means to enroll in the plan you must call the plan agent and fill out paperwork. Again, this isn't an onerous amount of paperwork. They simply need to verify that you do, in fact, own the shares and where to place the DRIP-purchased shares. A few funds offer automatic enrollment, meaning investors need to take action if they do not want to participate.

Once enrolled, investors authorize the plan agent to purchase shares on their behalf. Shares are held by the plan agent and are registered on behalf of each participant. Because of this, DRIP participants typically end up holding shares in two places: with the original broker or advisor and with the plan agent. Investors can withdraw from programs at any time. Generally, if participation is cancelled before a distribution has been declared, that distribution will be paid in cash. Most funds also allow investors to drop out and re-enter DRIPs as often as they'd like with no penalties.

Purchasing and Selling Shares
The price at which shares are purchased as well as the fees associated with purchasing those shares is perhaps the most important feature for investors to understand fully before participating in a DRIP. This is a big benefit that should not be overlooked and is the reason we are so keen on DRIP participation. If a fund's shares are trading at a discount at the time of the distribution, most funds will purchase shares for DRIP participants in the open market. In other words, you get the share price. If shares are trading at a premium at the time of the distribution, most funds will issue new shares to investors, keeping the distribution as an asset on their balance sheets and selling the new shares to investors. Such shares are issued at the greater of the current net asset value or a percentage of its share price (typically 95% or 98%). We consider these to be best practices when it comes to DRIP reinvestment policies, as shareholders are receiving the most advantageous price.

Cara Esser is a closed-end fund analyst at Morningstar.
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