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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.

The fund takes $9 million from total assets and distributes it to shareholders. The total assets of the fund fall to $91 million, just like with our share repurchase example. However, no shares were repurchased by the fund. So, there are still 10 million shares outstanding. As a result, the fund's net asset value decreases to $9.10 per share ($91 million in total assets spread across 10 million shares).

Clearly, the return of capital is not the same as a share repurchase.

Reinvesting the Return of Capital
But, the spouters of this nonsense may argue, the examples don't take into account two things: reinvested distributions and taxes.

Reinvesting the distributions doesn't make a difference. Let's show the math.

For the sake of argument, we'll assume that 100% of the distributions are reinvested--which isn't the case as the vast majority (90%) of distributions are consumed by investors as income. And we'll also look at what happens when a CEF trades at a discount and at a premium.

When a CEF trades at a discount, the reinvestment price is typically the market price and the shares are repurchased on the open market. This means that no new shares are created. In this example, we assume that the total fund distribution is the same $9 million and that the share price remains at a 10% discount, or $9 per share. The result is the same as it is when the CEF simply distributes the capital. Why? There is no change because the fund still dispersed $9 million and the shares outstanding remain at 10 million. The effects of the share repurchase, when the shares traded at a discount to NAV, happen in the marketplace--outside of the fund. Reinvesting the return of capital at a discount does not affect the fund or the depletion of its NAV.

Now, let's take a look at what happens when the fund trades at a premium and the return of capital is reinvested. The standard reinvestment policy of CEFs is that, when the CEF is trading at a premium, the repurchase price is the greater of 95% (sometimes 98%) of the market price or NAV. For our example, let's assume that the fund is trading at a 10% premium to NAV, or $11 per share. Ninety-five percent of $11 is $10.45 per share, which is greater than the $10 NAV, so the reinvestment price would be $10.45 per share.

Importantly, when distributions are repurchased and the fund is trading at a premium, the fund issues new shares--the shares outstanding will increase. To find out by how much, we'll take the $9 million in total distributions, assume a 100% reinvestment (which is ludicrously high), ignore any transaction costs (reinvesting typically has a bit of a commission tied to it), and divide that by the $10.45 per share reinvestment price. That results in the creation of about 861,244 new shares outstanding that go to the investors.

The net result is that the fund still has $100 million in total assets, as the entire distribution was reinvested into new shares and the distribution reverts to the fund. However, there are now 10,861,244 shares outstanding, which leads to a net asset value per share of $9.21.

But aren't the tax effects are the same between a return of capital and a share repurchase (I'm playing devil's advocate)? No, they are not.

Return of capital, for tax purposes, is treated as a write-down in the cost basis. If you purchased a fund for $10 per share and received $1 in return of capital, your cost basis would be $9 per share. Any resultant capital gains taxes incurred upon the sale of the CEF would use $9 per share, not $10, as the cost basis. With return of capital, taxes are deferred but don't go away.

In a share repurchase, there are no direct tax consequences. The fund itself repurchases the shares. It's a very tax-efficient method of using excess cash, and many corporations do it. There can be indirect tax consequences, as hopefully the share price increases as the economic benefits generated by the CEF--or company--are spread across fewer outstanding shares. But, to our point, the tax effects are not the same as a return of capital.

Myths abound for most investors about CEFs. By reading our articles, hanging out on our discussion boards, and using basic common sense, I hope you've been able to both avoid the pitfalls of such myths and--ideally--even swung them to your advantage against less-knowledgeable investors in the marketplace. Oftentimes, ill-thought ideas aren't easy to spot. The notion that return of capital is--or ever could be--equivalent to a share repurchase falters on the basis that return of capital doesn't repurchase shares, even under the ludicrous (but giving the ill-thought notion every advantage) assumption that 100% of the distribution is reinvested. Some myths can be speared using simple math.

Click here for data and commentary on individual closed-end funds.

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

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