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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.

In practice, the majority of funds purchase shares for plan participants at the market price if shares are trading at a discount. And when shares are trading at a premium, most funds follow the pricing discussed above. But there are funds with very different pricing schedules, which is why you need to look at the specifics of your fund's DRIP. A number of Aberdeen funds, for example, do not issue new shares but purchase shares at the market price, regardless of whether it's selling at a discount or premium. In another example, if shares are trading at a premium, Cornerstone Progressive Return Fund CFP, Cornerstone Total Return Fund CRF, and Cornerstone Strategic Value CLM will issue new shares to investors at the lower of NAV or the average closing share price over a five-day trading period, as Taggart previously discussed here.

Once a distribution is declared, most funds set a timeline for purchases (say, within 30 days of the declaration of the distribution). Because shares can be purchased over more than one trading day, shares may be bought at different prices depending on the market price over the purchase period. Usually, the average purchase price is used to determine the exact number of shares bought for each investor.

Fees charged for reinvesting distributions vary widely, but most funds charge some service fee and a prorated commission that is generally lower than the fees brokers charge for open market purchases. Some fund families even pay the service fees for repurchasing or issuing shares; their investors pay only brokerage fees.

When an investor wants to sell, shares are sold by the plan agent and the proceeds are sent via check or by deposit into a bank account. Because the plan agent holds only the DRIP-purchased shares, if an investor wants to sell out of the fund in its entirety, he may be required to make two transactions: one with the plan agent and one with his broker. Fees associated with selling shares from the DRIP are similar to those levied for purchasing shares and generally include a service fee and prorated brokerage fee. One of BlackRock's plan administrators, Computershare Trust Company, for example, charges a $2.50 sales fee in addition to a fee of $0.15 per share sold.

Plan agents send periodic statements to investors, sometimes as often as monthly. At the end of the tax year, investors will receive a 1099 tax form detailing any tax-triggering events due to reinvesting the shares from the plan agent. Investing via a DRIP requires investors to track the cost basis of the reinvested shares to calculate any realized capital gains or losses for tax purposes. This can become cumbersome as shares will be purchased at varying prices across time. Typically, such tax statements will provide the necessary information for filing taxes each year, but it may be appropriate to contact a tax professional.

DRIP Alternative
As mentioned earlier, most CEF investors do not participate in their fund's DRIP. There are likely a few reasons for this, one being that an investor simply does not want to purchase additional shares of the fund. But long-term shareholders are strong candidates for participation. The appeal is obvious: For a bit of paperwork on the front end, investors can purchase shares at an often discounted price for a small fee. Why, then, is the participation rate so low?

Self-directed investors may have access to distribution reinvestment through brokerage firms. This is different from the company-sponsored plan but is often an appealing option. For funds selling at a discount, this option may make more sense for investors. Little to no paperwork is required and shares do not have to be re-registered in the investor's name. Simply sign up, and shares are purchased at the market price on the distribution date for little or no commission. As of Jan. 31, nearly 60% of all CEFs were selling at discounts to NAV, meaning the price at which a broker may repurchase shares is likely identical to the fund-sponsored DRIP plan. If the broker charges no fee for this service (and many do not charge fees), investors are actually better off. What's more, all of the shares are held in one place with the broker.

On the other hand, long-term investors holding funds that typically trade at a premium can benefit from a DRIP by purchasing shares at a discount to the market price for a small fee. And not all brokers allow reinvestment of distributions. Long-term investors without access to this service should consider participating in a company-sponsored DRIP.

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