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What You Should Know About CEF Distributions

Jeremy Glaser
Steven Pikelny

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. Many investors see closed-end funds as income-generating machines, but what should they know about those distributions? I'm here today with Steve Pikelny, a closed-end fund analyst, to take a closer look.

Steve, thanks for talking with me today.

Steve Pikelny: Thanks for having me, Jeremy.

Glaser: Let's talk a little bit about those distributions, about that income. The distributions that are coming from a closed-end fund are little bit different from say a dividend from a stock. What kind of information are you going to get about this distribution? What's the fund family going to tell you?

Pikelny: Well, the fund has to split the distribution into four different parts for tax purposes because each part is taxed at different rate. The first one is investment income, which corresponds to the underlying holdings, whether they are getting dividends from equities or coupon payments from fixed-income securities. And these are taxed at the individual investor's income tax rate. Then after that you have short-term and long-term capital gains, and these each have different tax rates. Then finally if the fund is returning capital to the investors as part of the distribution, then since it's a return of capital, it's not taxed.

Glaser: Let's take a closer look at those four categories. Starting with investment income, what should investors know? What's important to look out for?

Pikelny: Investment income for equity funds [is one thing]; this could be mainly composed of dividends. So depending on the fund whether or not it's geared toward growth or geared toward value, it might compose a larger part of its distribution from income or capital gains. For fixed-income funds, you normally expect most of the distribution, if not all of the distribution, to come from investment income because they are fixed income and they have coupon payments. Depending on what kind of asset class you are in, you might not normally expect as much of the distribution to come from capital gains as from income.

Glaser: Let's take a look at those capital gains for both the short term and long term. What's happening there? What does that represent? Should you be worried if too much of that income is coming from capital gains versus investment income?

Pikelny: I think that again it does depend on the asset class. If you're talking about equity funds, then it's not unlikely to see equities grow in value. And when the fund realizes some of those capital gains, they could put it into their distribution. For fixed-income funds that's a little bit more worrisome because you're not really buying a fixed-income fund with the expectation that the underlying holdings will appreciate in value.

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Glaser: Return of capital is the final area. It's probably the trickiest area. Can you walk us through exactly what return of capital is and when it might potentially be a red flag?

Pikelny: One thing that you should at least keep in mind is when a fund is returning capital and then I guess kind of dig down into some of the reasons why it might be doing that. The best reason that it would be doing it is if it corresponds to unrealized capital gains. Say an equity fund is holding Apple, and Apple goes from $500 to $600. If the managers don't want to sell it, but they still want to maintain their distribution, they might return capital, and that just corresponds to the rise in Apple's share price. But even though they didn't sell it, it's still part of the return.

I guess sort of a neutral situation for closed-end funds is if the fund is not trading at a premium or a discount and the fund just returned shareholders' money back to them. That's not necessarily a bad thing. It just kind of obscures what the true distribution rate is because if the fund is paying say a 6% distribution rate and 1% of that is return of capital, then from the shareholders' perspective they're essentially getting a 5% distribution rate. And if the fund is trading at a premium, that could be even worse. That's what we call destructive return of capital because when the fund returns its capital, if investors want to reinvest this money because they're essentially getting their money back, then they'd have to reinvest it at a premium. So, there's some depreciation there.

Glaser: Once you have this breakdown, you see [that you have] this income [and that] this distribution is coming from these four areas. How do you know if that's sustainable or not? How do you take a look at a fund and say "OK, it's giving a good distribution now, but is that something that I can count on in the coming years?"

Pikelny: For equity funds it's a little bit harder to predict that because a lot of times their returns are based on a lot more capital gains, and depending on how the stock market is moving, it could change things. In fixed income it's a little bit more predictable. One measure you could look at is the fund's balance of undistributed net investment income, which sounds like a mouthful, but if you just break it down it's just the fund's net investment income, the income net of the expense ratios and debt and all that that has been accumulated over a long period of time. If the fund has a large reserve of undistributed net investment income, or UNII as we call it, then that can be an indication that the fund will maintain its distribution or if it's large enough maybe even increase it in the future. I guess the second thing is that you look at how much income it's earning relative to how much it's paying out. So just simply look at the inflows versus the outflows, and if the fund is consistently earning enough income to cover this distribution, then that's a good indication that it might be able to keep up with it.

Glaser: Steve, thanks for walking us through distributions today.

Pikelny: Sure, thanks.

Glaser: For Morningstar, I am Jeremy Glaser.