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.
To illustrate how calculating multiple distribution rates can potentially change an investment decision, let's look at a real-world example. The table below lists the alternative distribution rate we will discuss and the formulas for calculating them.
The table below lists pertinent data we will use to calculate these distribution rates for Denali Fund DNY along with the actual calculations. Note that these calculations are based on a semiannual distribution. DNY does not have a managed-distribution policy.
A quick disclaimer: The illustration is not meant to be an endorsement or a rejection of this fund. We simply want to show how to calculate various distribution rates using actual numbers. All data is as of April 9, 2012, and is from Morningstar's Traded Funds Center.
The final table compares the stats from DNY with its CEF U.S. equity peer group's averages.
Right off the bat, DNY's total distribution rate looks strong with a higher-than-average rate (8.96% versus 6.45%). But, upon closer inspection, the fund's latest distribution included just $0.02 per share of income. DNY's income-only distribution rate is 0.22%, while the peer average income-only distribution rate is 2.30%. This is not an anomaly for DNY. The fund distributed $0.02 per share of income during 2011 and $0.03 per share of income during 2010. Adding capital gains to the distribution-rate calculation gives DNY a boost (8.96% versus 3.17%). From these simple calculations, we can see that the fund relies heavily on capital gains (which is normal for an equity fund) but more heavily than other funds in its peer group. In a market downturn, this fund may have a difficult time keeping its distribution at the current level or it may rely on return of capital to meet payments. In fact, the fund did just that in 2008. It paid 18.8% of its total distribution from return of capital and also lowered its distribution in 2008 and 2009. The fund has since never used return of capital and has slowly increased the distribution.
While DNY typically does not return capital (aside from 2008), many of its peers do. The difference between the peer group's average total distribution rate and its income plus capital gains distribution rate is explained by the use of return of capital.
For funds utilizing leverage, it's important to gauge how leverage affects the distribution rate. One way to ballpark this is to calculate a "core yield." To be clear, this is a back-of-the-envelope calculation that gives us an idea of how much the fund might pay out if it weren't leveraged. To calculate a core yield, simply divide the current distribution rate by 1 plus the leverage ratio. DNY's leverage ratio is 35%, giving it a core yield of 6.44%, slightly higher than the peer group's average of 5.89%. This is a strong sign for this fund's distribution. It does not use as much leverage as some of its peers, which means it is not relying on its leverage to generate excess income and capital gains to distribute.
Another important consideration is the discount or premium at which the fund sells because the share price is what an investor experiences. Shares are bought and sold at the market price, not the NAV. A fund selling at a discount gets a boost to its NAV-based distribution rate. We call this "yield enhancement." DNY was selling at a 20.8% discount at the close of trading on April 9, boosting its total distribution rate at share price to nearly 11%. On average, the peer group is selling at a slight premium, which actually lowers the group's average distribution rate at share price to 6.38%.
Investing for retirement is essential, and income generation often plays an outsized role. The quality of income generated by a fund and its ability to sustain this distribution in the future are of great importance. Looking past the ubiquitous total distribution rate provides a clearer picture of the fund's underlying distribution policy.
Gaining a true understanding of a fund's distribution will help you avoid funds that treat investors poorly through an ill-thought distribution policy. Long-term investors should be more concerned about the sustainability of both a fund's distribution and its NAV. Let such confused fund executives fool other people all of the time. Our readers don't have to stand for such wayward policies; you're far too sophisticated for such games.