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Do the Math

Return of capital is not the same as a share buyback, and simple math shows this.

Mike Taggart, CFA, 11/09/2012

Investor beware. When it comes to any type of investing, that's the first rule. Sometimes, it's more difficult to see that something's simply not true. It's the old line about lies, darned lies, and statistics. But other times, your own gut instinct can tell you if something rings true or not.

Closed-end funds are perhaps a little different from most securities when it comes to this warning. As a niche investment type that are considered paragons of inefficient investing, there's a lot of nonsense spouted about them. Over the years, we've tried our best to alert our readers to harmful, long-standing myths about investing. There's a lot of short-term nonsense that gets spouted about CEFs, too, such as ill-informed people attempting to justify a CEF's high premium on the basis that its leverage costs are two tenths of a percentage point less than that of similar CEFs.

One of the latest notions I've heard is that return of capital is simply the same as a share buyback, or share repurchase. This idea cracks me up. Indeed, the two are the same, if you take away the share buyback piece. I learned of this new view months ago but dismissed it as something so obviously wrong that it would die off on its own. Alas, it seems some fund executives have picked up on this spin. Clearly, someone must stand up and say enough is enough. In fact, return of capital and share repurchases are nothing alike, as can be proven by simple math.

A Standard Share Repurchase
It's a simple proposition to refute this, but let's take the time to walk through the argument. In a standard share repurchase, a CEF--or any company for that matter--uses capital to repurchase shares, and then those shares are no longer outstanding. In essence, the capital is used to shrink the pie.

Let us use a fictitious example of an unleveraged CEF with a net asset value of $10 per share, trading at a 10% discount to its NAV ($9 per share), with 10 million shares outstanding. The total assets of the fund are, thus, $100 million. Because the CEF is trading at a discount, the board of directors authorizes a share repurchase of 10% of the outstanding shares and--miracle of miracles--the fund immediately repurchases 1 million shares, with no market price impact, at $9 per share. The fund spent $9 million dollars to repurchase 1 million shares.

The result, as seen above, would be that the fund now has $91 million in total assets ($100 million prior total assets - $9 million spent on repurchase). It has 9 million outstanding shares (10 million prior shares - 1 million shares repurchased). Thus, the net asset value actually increases to $10.11 per share, as buying shares back at a discount is accretive to the NAV. Note that we cannot predict the effect the share repurchase will have on the CEF's share price, though we could hope that it will increase as well.

Return of Capital's Effect on NAV
Now let's take an identical sister fund and assume that the board of directors--having approved the share repurchase of the other fund--decides to allot the same amount of capital ($9 million) to a return of capital for this fund. Whether or not this return of capital is constructive (comes from unrealized capital gains) or destructive (comes from a return of investors' principal), the outcome would be the same.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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