Investors should consider these dividend-seeking equity funds for their tax advantages.
Death and taxes, goes the adage, are the only certainties in life. But another certainty is that most citizens don't like paying taxes and frequently look for sometimes-complicated loopholes to lower their tax bills. But there are a number of easily exploitable methods to lessen the sting of taxes.
As part of the 2003 Bush tax cuts, a cap of 15% was placed on the taxes that individuals paid on "qualified dividends." (For low-income investors, the rate is zero.) Previously, all dividends received were taxed at an investor's ordinary income tax rate. Even now, nonqualified dividends are still taxed at the investor's ordinary income tax rate. The preferential tax treatment of qualified dividends has been renewed twice (once under former President Bush and once under President Obama) and is now set to expire at the end of this year.
There is much uncertainty surrounding the possible outcome of the current tax debate, and it's likely to be a divisive subject in Washington during the election year. Because of this uncertainty, investors may be overlooking a worthwhile category of closed-end funds, or CEFs: the tax-advantaged equity fund. While many equity CEFs distribute a portion of qualified dividends to investors, few focus on these preferential dividends as an integral part of the strategy. Some of these funds also manage capital gains and losses in an attempt to make the portfolio tax-neutral from a capital gains perspective.
Dividends paid by firms must meet several criteria to qualify for the lower 15% tax rate. First, assuming expiration at the end of 2012, the dividend must be paid prior to Dec. 31, 2012. Second, the dividend must be paid by a U.S. corporation, a corporation incorporated in a U.S. possession, a foreign firm in a country that is eligible for benefits under a U.S. tax treaty, or on a foreign firm's stock that can be readily traded on in the U.S. stock market (such as an ADR). Finally, the stock paying the dividend must be held for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date (the first date following the dividend declaration on which the buyer of a stock is not entitled to receive the dividend). Taxpayers can benefit from this lower tax rate on any individual dividend-paying stock holding, assuming the above criteria are met. These rules can be very complicated for ordinary investors to navigate, but the rules are well ingrained for professional portfolio managers who deal daily in this realm. In the context of CEFs specifically, funds receive qualified dividends and pass them directly through to the investor.
Tax-Advantaged Equity CEFs
Like a municipal-bond investment, the biggest benefit of tax-advantaged funds is the ability to boost aftertax distribution, meaning the distribution that an investor keeps after paying all applicable taxes. Unlike a municipal investment, the advantages aren't obvious. Investors must dig though some tax forms to find the percentage of the distribution that qualifies for the lower tax rate. (These forms are released in the first quarter of each year, detailing the previous calendar year's breakdown and made available to both investors and noninvestors on a fund family's website.)
The table below lists seven CEFs categorized as following a tax-advantaged approach to equity investing. The table includes the funds' current distribution rates at net asset value and various aftertax distribution rates.
As an example, Eaton Vance Tax-Advantaged Global Dividend Opportunity ETO has a 6.26% distribution rate. The fund paid the entire distribution from qualified dividend income, so the investor was taxed at 15% instead of the ordinary income tax rate that we assumed was a 28% effective tax rate. This creates an aftertax distribution rate of 5.32% (6.26% x (1 - 0.15)) versus 4.51% (6.26% x (1 – 0.28)).
For funds that do not pay the entire distribution from qualified dividend income, we calculated the aftertax rates assuming realistic rates investors would pay: zero for return of capital (the cost basis is lowered and taxes are deferred), 28% for ordinary income, and 15% for qualified dividends. Nuveen Tax-Advantaged Total Return JTA, for example, paid 55% of its total distribution from return of capital: 5% of the total distribution was from ordinary income and 45% from qualified dividends.
While it's not rocket science to say that investors receive a boost to aftertax distribution rates when the tax rates are lower, the magnitude is significant. Funds paying 100% of their distributions from qualified dividends get an 18% boost to their distribution rates, compared with the aftertax distribution rates under a 28% taxation scenario. Investors in a higher tax bracket would experience an even larger boost. What's more, many of these funds are selling at discounts, which will increase the distribution rate an investor actually earns based on the price at which the fund is purchased. Clearly, the tax advantage can significantly benefit investors, but which funds are best?
Tax-Advantaged Equity CEFs We Like
The table below lists the same seven CEFs as the table above, the current discount, the current distribution rate, and various performance data. The funds follow similar strategies seeking dividend-paying common and preferred shares. Each of the funds holds a portion of assets in global firms, but three invest nearly half of their assets in foreign stocks. All but one fund utilizes leverage (John Hancock Tax-Advantaged Global HTY), and the funds' leverage ratios sit around 1.40 (total assets to net assets) each.
Eaton Vance Tax-Advantaged Dividend Income EVT
This Silver-rated fund has a lot going for it. Managers are focused on individual stock-picking within sectors, mimicking the weighting of the Russell 1000 Value Index, and they have been fairly successful. EVT must invest at least 80% of its assets in securities that are eligible to pay qualified dividends and, historically, 100% of every distribution has been from qualified dividends.
Managers hold both domestic and foreign names and engage in a dividend-capture strategy with some foreign holdings. Foreign firms tend to pay dividends only twice per year, limiting the turnover that generally comes with a dividend-capture strategy. Generally, we are opposed to such strategies and have written extensively on our distaste of the strategy. But this fund employs the strategy on only a small portion of the entire portfolio and uses the capital losses the stocks generally incur after the dividend is paid to offset other capital gains, making the strategy tax-neutral from a capital gains perspective.
Overall, performance has been decent against various peer groups. The fund beat the closed-end tax-advantaged equity peer group average return in four of the past eight calendar years, beat the open-end large-value peer group in seven of the past eight, and beat the closed-end large-value group average in three of the past six. While the record looks mixed, the fund generally outperformed by more in terms of gains than underperformance in terms of losses. Over the latest three-year annualized period, the fund gained 32%, the CEF equity tax-advantaged peer group average gain was 31%, the broader large-value CEF peer group gained an average of 28%, and the open-end large-value peer group gained an average of 23%.
The fund's risk has been mixed against peers, but investors have been rewarded for this risk. Its three-year standard deviation is 19%, the closed-end large-value average is 16%, and the open-end large-value average is 20%.
The 7% (pretax) distribution rate is just under the peer average of 7.5% and, since inception, the entire distribution has been paid from income that qualifies for preferential tax treatment. The fund's fiscal 2011 fees were among the lowest in the peer group.
John Hancock Tax-Advantaged Dividend Income HTD
HTD is also a Silver-rated fund. We like its investment policy, which is fairly unique among peers. It focuses on utilities, which tend to be strong and stable dividend-payers, and does not have a large holding in banks. As of the end of January 2012, the fund held more than 70% of its assets in utilities compared with the peer average of 18%. It also had a smaller-than-average allocation to banks (4% versus 14%). These utility holdings have held back performance recently, as has its small allocation to banks, which have been improving. But the allocations have helped long-term performance against the tax-advantaged peer group.
The fund beat the tax-advantaged peer group's average return in five of the past six calendar years. It gained 48% over the latest three-year annualized period, compared with the peer average gain of 31%. The broader large-value CEF peer group gained an average of 28% over the latest three-year annualized period, and the open-end large-value peer group gained an average of 23%. On top of strong returns, risk has been low on an absolute and relative basis compared with open-end peers. The fund's three-year standard deviation is 16%, the closed-end large-value peer group average is also 16%, and the open-end average is 20%.
The 6% (pretax) distribution rate is lower than the tax-advantaged peer average of 7.5%. Prior to 2010, the fund paid small portions of the distribution from capital gains and return of capital. The return of capital was partially destructive in 2008 and accounted for 28% of the entire distribution. In calendar years 2010 and 2011, the fund's entire distribution qualified for preferential tax treatment. The fund's undistributed net investment income, or UNII, balance has been increasing and now sits at $0.07 per share.
The fund also had the lowest turnover rate in the tax-advantaged peer group during fiscal 2011 (16% versus the average of more than 70%), and its expenses are on par with the tax-advantaged and large-value CEF peer group averages.
Nuveen Tax-Advantaged Dividend Growth JTD
Table 1 shows that only 60% of JTD's 2011 distribution was from qualified dividends, but this fund employs a call-writing strategy on top of its dividend-seeking investment policy. The call options generate income that is categorized as capital gains and often, for accounting reasons, distributed as return of capital (if done correctly, it's not destructive). Return of capital can have its own tax advantages by lowering the investor's cost basis, delaying taxes until the fund is sold. But in calendar-year 2011, according to Nuveen's final tax breakdowns, no return of capital was distributed and 40% of the income distributed did not meet the criteria of qualified dividends. In the past, the fund's return of capital has not been destructive, aside from 2008.
As of the close of 2011, the fund had only a small number of call options written and that is generally not a large part of the strategy. As of Jan. 31, 2012, the fund's sector allocations were in line with tax-advantaged peer averages. The largest concentration was in banks (about 10% of assets).
This fund is relatively new, launched in June 2007, and performance has been slightly better-than-average. In its first full calendar year in existence, the fund lost 32%, a bad start (the tax-advantaged peer average lost more than 40%, however). The fund outperformed the group in 2010 and matched performance in 2009 and 2011. Overall, the fund gained 31% over the latest three-year annualized period, compared with the peer average gain of 31%. Recent performance has been better, and the fund is outperforming the peer group over the past year by more than 2 percentage points. Looking at the broader large-value CEF peer group, the average gain was 28% over the latest three-year annualized period and the open-end large-value peer group gained an average of 23%.
And the fund's risk has not been too high. Its three-year standard deviation is 16%. The closed-end large-value peer group average is also 16%, and the open-end average is 20%.
As the need for income-generating investments increases, investors need to look for all the advantages they can find. Despite the popularity of municipal investments for tax-conscious investors, holding a portfolio of only municipal bonds or even municipal funds is not a diversified approach to investing. Adding some equity exposure does not have to mean that you will miss out on tax breaks, and the above-listed funds provide a great opportunity to earn income with preferential tax treatment. Many of these funds have also seen their discounts widen significantly in recent months as the concerns over the tax debate heat up. EVT, for example, is selling at a 10.5% discount, much wider than a year ago when it was less than 6%.
To be sure, the renewal of the preferential tax treatment is far from certain, and 2012 may be the last year for investors to take advantage of these funds' tax advantages. But, aside from lowering the tax bill, the three highlighted funds are good investments even if the tax advantage goes away. The outperformance of each fund over the broader large-value peer groups is indicative of a strong investment process and capable management team.