Our thoughts on IPOs, return of capital, and discounts and premiums in CEFs.
Last Thursday, several members of Morningstar attended the 13th annual Capital Link conference for closed-end funds and exchange-traded funds. The conference was widely attended by analysts, portfolio managers, and product specialists. Some key topics included sector-specific trends in areas like energy investing and emerging markets, as well as product-level issues such as how to raise capital for CEFs and master limited partnerships. Morningstar's Steve Pikelny moderated the CEF industry round table panel discussion.
On the CEF front, several themes emerged from the various panel discussions and informal conversations with industry participants. Most discussions centered on the difficulties of raising capital, improving investors' understanding of CEFs, and how to use CEFs in a broader portfolio.
Closed-End Fund IPOs
We haven't seen many CEF IPOs in the past year, and with good reason. Of the last 10 CEF IPOs, five were MLPs, reflecting investor appetite for equitylike investments with high yields. The lack of recent equity and fixed-income CEF launches reflects a couple challenges facing the industry. First, it appears that investors have shied away from fixed-income CEFs that display any type of interest-rate risk, as these funds could be prone to losses in a rising-rate environment. Perhaps more concerning though, is what we view as a flawed IPO process, which leaves investors at an immediate disadvantage due to the high upfront underwriting fees. As many CEFs have traded down to sizable discounts over the past six months, investors are prudent to ask whether they should buy newly launched closed-end funds. Why buy a premium-priced fund that will likely fall to a discount within two months when many existing funds already trade at attractive discounts?
Investment firms must improve the general perception that closed-end IPOs are not worth investing in. One way to fix this is for issuing firms to cover the IPO expenses for investors. We're all for solutions that lower costs for investors, and if lower expenses lead to new fund launches, sponsoring firms can potentially make up for these lost fees in the form of a stream of management fees for years to come. Until changes are made, however, we'd continue to suggest investors view CEF IPOs very cautiously.
Taxes and Return of Capital
Taxation of closed-end funds is complicated, to say the least, which is why it's often wise for investors to own these vehicles through tax-deferred retirement accounts (except for municipal-bond funds and other tax-advantaged investments). For those that own closed-end funds in regular taxable accounts though, extra attention is required to understand how they meet their distribution payments.
CEFs pay distributions through a combination of net investment income, realized capital gains, and return of capital. The tax implications of income and capital gains are straightforward. Any income generated is taxed at the investor's marginal tax rate, while any capital gains distributed incur either short or long-term capital gains taxes depending on how long the fund held the underlying holding.
If a fund is unable to meet its distribution through income or capital gains, it will often fill this shortfall in by returning capital to investors. In general, return of capital lowers the investor's cost basis, thereby increasing its future potential capital gains or limiting future losses. That said, investors should understand that distributions don't always represent investment profit, and could instead equate to the fund company giving the investor his money back. A fund's distribution is officially categorized as income, capital gains, or return of capital at the end of each tax and fiscal year. This lack of real time information can add to the confusion.
One common misperception is that all return of capital is bad, but this isn't always the case. It might make sense for a fund to return capital if its shares trade at a persistent discount to net asset value. For example, if a fund has a $10 NAV but trades at a $9 share price, the market is valuing each dollar at 90% of its portfolio value. Unless the fund has to give up unique investment opportunities to do so, investors should prefer that the fund return capital at its full value, as it allows them to reinvest in the fund at a discount. On the flip side, a fund trading at a premium is valuing each dollar invested in the fund above the portfolio value. In that case, investors are made worse off by return of capital, as it either diminishes their total exposure to the fund, or forces them to reinvest at a premium.