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Is Destructive Return of Capital as Bad as It Sounds?

For closed-end funds, the answer depends on the premium or discount.

Steven Pikelny, 06/15/2012

One mistake that rookie closed-end fund investors often make is taking a fund's distribution at face value. Experienced CEF investors know there's more to the story than the published number. Distributions can be paid from investment income, long-term capital gains, short-term capital gains, or return of capital. Income and capital gains are products of investing the underlying assets and either reaping dividends and interest payments or realizing returns on assets. Return of capital is more nuanced. It can act as a placeholder for unrealized capital gains, but it can also be used "destructively," acting as smoke and mirrors to give the illusion that a fund's true distribution is higher than it actually is. (For more detailed information on this distinction, read this article or check our CEF Solutions Center). Put simply, a consistent and large distribution from destructive return of capital is harmful to shareholders.

Understanding Return of Capital
For those new to CEFs, a quick review of return of capital is in order. Consider a fund that holds only cash, with a net asset value of $100 per share. If the fund distributes $10 to shareholders, this is comprised entirely of return of capital because the fund didn't earn any income or book capital gains. The fund's NAV decreases by the amount of the distribution to $90. At the end of the day, shareholders still wind up with $100 ($90 in NAV and $10 in cash from the distribution). Aside from the potential confusion stemming from a published 10% distribution rate, the shareholders are technically no worse off. The decision to reinvest these distributions and the price at which they are reinvested change this calculation.

Consider now the same CEF with a NAV of $100 per share, trading at a 20% discount (the share price is $80). The fund distributes $10 per share (still return of capital), and the investor has decided to reinvest all distributions back into the fund. Shareholders make out quite well in this case. Assuming investors are reinvesting distributions at the fund's share price, for each $1.00 an investor reinvests, they would then own $1.25 in assets. Alternatively, reinvesting the distribution would be detrimental if the fund traded at a 20% premium (with a share price of $120). In this scenario, reinvesting $1.00 would correspond to owning just $0.83 in assets.

The precise premium at which reinvestment becomes detrimental depends on the fund's dividend reinvestment program, or DRIP. For example, if a fund is trading at a premium, many CEFs will automatically reinvest distributions at the higher of NAV or 95% of the share price. This means investors break even if the fund trades between a 0% and 5.26% premium. In the case of a discount, funds typically buy shares in the open market, which is advantageous to shareholders.

Return of Capital at a Discount
In theory, taking advantage of this should be an easy way for investors to make a quick arbitrage profit. But, in reality, the issue is slightly more complicated. From the shareholder's perspective, receiving large amounts of return of capital from a fund trading at a large discount can be advantageous, destructive or not. For example, Clough Global Opportunities GLO trades at a 15.5% discount. If the fund liquidated half of its portfolio and returned the proceeds to shareholders, even after accounting for the taxes from realizing capital gains, shareholders would receive a significant benefit. What's more, a massive reinvestment of this capital (through a DRIP) could narrow the fund's discount. By the same logic, RENN Global Entrepreneurs Fund RCG, which trades at a 31.3% discount, might benefit shareholders the most by liquidating its entire portfolio. But before rushing out to buy CEFs trading at huge discounts, it's important to understand why partial (or full) liquidations do not routinely happen: Decreasing a fund's asset base translates to lower fees for fund families and portfolio managers. Investors shouldn't hold their breath waiting for this to happen.

Currently, several CEFs trade at substantial premiums and use destructive return of capital as a portion of their distributions. However, it's important to distinguish between funds that use return of capital as a supplement and funds that compose their distributions entirely or mostly of return of capital. The table below lists the CEFs falling into the former category with the largest increases to their distributions coming from return of capital. (We have excluded covered-call and master limited partnership funds from our analysis, as their accounting practices generally necessitate that a large portion of distributions be classified as return of capital. For more information on this topic, read these two articles).

The column labeled "Effect of Reinvesting ROC (BPs)" shows the total basis point increase to the fund's distribution rate due to reinvesting return of capital at the fund's current discount. Calculating the adjusted distribution rate is particularly important when examining a fund. This calculation takes into account the cost of reinvesting returned capital while also accounting for the yield enhancement arising from the fund's discount. To calculate this, we first removed the effects of return of capital from the total distribution rate, leaving only the distribution rate attributable to investment income and capital gains. Next, we found the total effect of reinvesting return of capital (distribution rate attributable to return of capital)*((NAV/share price) – 1). Finally, we added these two numbers together. Although the effect is often insignificant, it can be a substantial addition to some funds. For example, Dividend and Income Fund DNI adds 92 basis points to its distribution rate using this calculation.

Steven Pikelny is a closed-end fund analyst at Morningstar.

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