Gaining a true understanding of a fund's distribution will help you avoid funds that treat investors poorly through an ill-thought distribution policy.
Income. It's the holy grail for retirees. We hear it again and again from investors but also from fund companies and portfolio managers. In my time covering closed-end funds, or CEFs, at Morningstar I've had frequent conversations with portfolio managers running myriad strategies: Fixed-income and equity, domestic and global, growth and value. No matter the underlying strategy, inevitably, the conversation turns to their fund's ability (or inability) to generate sufficient income and capital gains to meet stated distributions.
A while back, I spoke with a portfolio manager whose fund has a managed-distribution policy (meaning it pays a certain percentage of the fund's net asset value each year, regardless of the actual income and capital gains earned). This specific policy, I believed, was unsustainable and detrimental to long-term shareholder value. The fund continuously relied on destructive return of capital to meet the distribution policy, which was slowly eating away at the fund's NAV, further hindering its ability to meet future distribution payments. This manager's defense (a common defense in the industry for these practices) was that investors demand income. The fund is simply giving the people what they want.
This kind of proclamation is often followed by an anecdote about how XYZ fund lowered its distribution rate and its share price plummeted, "hurting" long-term investors. So, they are giving investors the income they desire and protecting shareholders from an abrupt drop in share price by refraining from lowering a potentially unsustainable distribution. How kind of them. Here's something: If investors are truly long-term, what hurts them more--an unsustainable distribution that erodes at the fund's assets over the long term or a sustainable distribution that harms the short-term share price?
I firmly believe that these kinds of blanket statements are a disservice to CEF investors. The assumption that CEF investors are so blinded by income that they do not care how "yield" is generated (even at the expense of longer-term investment value) and cannot distinguish between distribution changes that are indicative of future income a fund is likely to earn and those that are destructive to long-term value, is ludicrous. It shows little respect for the sophistication of CEF investors, presuming all investors have one singular concern driving every investment decision.
I'm not going to proclaim that income isn't important or that CEFs should not be used to generate income. Many of our readers are retired or investing for retirement, making income generation especially important. And, as we have shown before, CEFs are a great vehicle for income generation. But investors need to look past superficial headline news (especially around distribution changes) and a fund's stated total distribution rate. Take a few minutes to calculate some alternative distribution rates that provide a clearer portrait of the fund's distribution policy. This information can change your investment decision and provide more context for distribution changes.
The Many Faces of "Yield"
Investors can easily find a fund's total distribution rate. On each fund's Quote page on Morningstar.com, we provide the distribution rate based on the fund's share price and based on its NAV. Morningstar calculates the total distribution rate by annualizing the most recent distribution payment (from all sources: income, capital gains, and return of capital) and divides it by the current share price and NAV. The result is a total distribution rate at share price and a total distribution rate at NAV. These provide a big-picture look at the distribution rate that includes all sources, sustainable and unsustainable, in the calculation.
Distributions from capital gains and return of capital are often considered less sustainable than distributions from earned income. Capital gains can be heavily impacted by market swings over which managers have little control (of course he can position a portfolio to benefit from these swings or to provide protection from the swings). Return of capital can be "good" or "destructive" depending on the appreciation or depreciation of the fund's underlying holdings, but generally, a fund that relies too much on return of capital may not have a sustainable distribution policy (this does not apply to MLP funds, which simply pass on to shareholders the return of capital they receive from their MLP investments). Income, on the other hand, can be earned from dividends and coupon payments from underlying securities. These sources tend to be more stable and predictable in the short term.