Morningstar Solutions
Morningstar Solutions
Return of Capital Part III
Slide 2: Return of Capital Part III

In Return of Capital Part I, we explained why return of capital occurs, and briefly outlined the different types of return of capital (RoC). In Part II, we delved further into pass-through and constructive return of capital. In Part III, we will discuss destructive return of capital.

Slide 3: Return of Capital Part III

Destructive Return of Capital
This form or return of capital can arise from two principal issues.

First, the executives forecasting the portfolio's distribution capabilities may have overestimated what the fund could pay out in any given year. In this case, we understand that even executives can err in judgment now and then. We would expect to see a reduction in the distribution to realign the amount to what the portfolio can actually provide.

In addition, the market can sometimes take a dive at year-end, so distributions that were estimated to be sustainable throughout the year are no longer able to be met.

Slide 4: Return of Capital Part III

Second, executives could be purposefully setting distributions at unsustainable levels. Fund executives realize that a CEF's distribution rate correlates highly with the share price investors are willing to pay. In fact, CEF distribution rates correlate highly with premiums.

One executive at a fund that we are not too keen on actually wrote that he found our use of the term "destructive" to be "frankly offensive." He argued that by returning destructive capital to the CEF's shareholders, the CEF had gone from a 15% discount to an 8% discount.

Do not let such argument fool you into putting your money into CEFs that primarily use destructive return of capital to meet their unsustainable distribution levels. Total return is all that matters.

Slide 5: Return of Capital Part III

Why is destructive return of capital so bad?

Destructive return of capital is simply your own capital being returned to you. This means you are paying a fund to give you your own money back, which is ridiculous.

For the fund, returning destructive capital erodes the investment portfolio's future earnings power. This will make it more difficult for the fund to successfully execute its investment strategy.

It will also necessitate, as history has shown time and again, reductions in the distribution amount.

Slide 6: Return of Capital Part III

We believe that CEFs using destructive return of capital consistently to artificially pump up their distribution rates are economic frauds that do a disservice to both their investors and to the CEF industry as a whole. But take heart: Most CEFs do not consistently use destructive return of capital.

Why can't the economic fraudsters be stopped? The simple explanation is that they follow the letter of the law. Such CEFs do disclose, as required by regulators, that their distributions come from return of capital. Unwitting investors, who do not understand the true source of the distribution, purchase the fund. This is one reason we advocate fully understanding CEFs before investing.

Slide 7: Return of Capital Part III

How can you tell if a return of capital was destructive?

Remember, a fund's net asset value is composed of the following:

  • Cash on hand
  • The portfolio securities' cost basis
  • Subsequent investment income
  • Subsequent realized capital gains/losses
  • Subsequent unrealized capital gains/losses
Slide 8: Return of Capital Part III

If a CEF has estimated that a distribution came fully or partially from return of capital, then the only sources must be either:

  • Cash on hand
  • Subsequent unrealized capital gains/losses

Furthermore, every distribution--regardless of its source--is deducted from the NAV. So, if a CEF's NAV plus its distribution decreases over a period, then any distribution attributed to return of capital is actually a destructive use of return of capital.

The underlying portfolio source was your own capital returned to you, minus the fees you pay to the fund in the form of expense ratios.

Slide 9: Return of Capital Part III

An example:

  • NAV at beginning of period = $10.00
  • Distribution during period (100% estimated to be return of capital)= $1.00
  • NAV at end of period = $9.00

In this case, the fund has returned $1.00 per share out of unrealized capital gains. The fund has had a NAV return of -10% and a distribution rate of 10%, combining for a total return of 0%. This was destructive return of capital. If a CEF has a total return less than the sum of its beginning NAV plus its distribution, and any portion of the distribution came from return of capital, then that was destructive return of capital and is a red flag.

Slide 10: Return of Capital Part III

Sometimes RoC can be a mix of constructive and destructive. An example:

  • NAV at beginning of period = $10.00
  • Distribution during period (100% estimated to be RoC)= $1.00
  • NAV at end of period = $9.50

In this case, the fund has distributed $1.00 as return of capital

  • $0.50 per share came from unrealized capital gains, making it a constructive use.
  • $0.50 per share came from destructive return of capital.

The fund has had a NAV return of -5% and a distribution rate of 10%, combining for a total return of 5%. Is this a good thing or a bad thing?

Slide 11: Return of Capital Part III

Cases such as these are really a judgment call.

If the CEF has a history of destructive return of capital, we would not give it the benefit of the doubt.

If the CEF does not have history of destructive return of capital, then we would look at how the underlying market had performed and likely speak with a fund executive to see what's going on.

Even here we would flag the fund for destructive return of capital, keep an eye on it, and see what develops. If the fund stopped distributing return of capital or reduced its distribution, we would be quick to view the destructive use as a one-time event.

Slide 12: Return of Capital Part III

Return of Capital Disguised as Something Else
As much as we detest destructive return of capital, there is another practice that is even more economically fraudulent, in our view.

This practice involves investing in extremely questionable strategies, especially dividend capture trading. Such strategies essentially launder return of capital into dividends.

Because these strategies have no merit, they do not create value. They are almost always destructive to your capital. As a shareholder, you not only receive your own capital back, but since it is now in the form of a dividend, you must pay taxes on the distribution.

Slide 13: Return of Capital Part III

The "dividends" you receive from dividend capture CEFs are really nothing more than taxable destructive return of capital. And, for the pleasure of receiving your money back, you pay the fund family an expense ratio in addition to paying Uncle Sam.

You can view the first of two articles on this topic here.

Slide 14: Return of Capital Part III

Tax Implications of Return of Capital
Many investors do not understand the tax implications of return of capital and mistakenly file incorrect tax returns.

Return of capital is treated differently under the U.S. tax code. Although a fund's monthly and quarterly distributions will include estimates of their sources in their accompanying press releases, fund families send out the actual sources once a year in 1099-DIV forms.

These forms are what you use to file your taxes. You do not use the estimates.

 

Slide 15: Return of Capital Part III

Return of capital lowers your cost basis.

This makes sense, since it's simply your own money being returned to you, minus your share of the fund's expenses.

The IRS doesn't care whether the return of capital was pass-through, constructive, or destructive. You should care, though.

Slide 16: Return of Capital Part III

Example:

  • Share price purchased was $10.00
  • Subsequent return of capital = $1.00
  • Share price sold was $10.00

Your cost basis would be the purchase price ($10.00) minus the return of capital ($1.00), or $9.00 per share. When you sell, your capital gain will be computed from this adjusted cost basis.

If you sell the CEF at $10.00, you may think that you had no capital gain. But the IRS will expect you to declare a $1.00 per share capital gain, computed as your selling price ($10.00) minus your adjusted cost basis ($9.00).

Slide 17: Return of Capital Part III

Return of Capital Key Takeaways

  • Return of capital is not always bad.
    --Pass-through and constructive return of capital are not economically pernicious.
    --Short-term/minor destructive return of capital can also be forgiven.
     
  • A CEF's consistent use of destructive return of capital to artificially pump a distribution rate should preclude it from further investment consideration. Do not put your money into such a fund.
     
  • Some investment strategies return capital in other forms.
     
  • It's important to understand the tax consequences of return of capital.
Accompanying Video
Return of Capital Part III
This slide does not have an accompanying video.