- A Closed-End Fund (CEF) “Managed Distribution Policy” regarding Section 19a-1, established capital gains on monthly and quarterly dividends based on a percentage of NAV per share.
- The “Managed Distribution Policy” may require Return-of-Capital (ROC) as “back-up” to this “Managed Distribution Policy”.
- GrowthIncome has discovered that as a Return-Of-Capital (ROC) dividend may increase it will make the “premium” higher.
- This has negative implications to the investors.
Under a "Managed Distribution Policy," Closed-End Funds (CEFs) specify a predetermined annual dividend yield that they will pay to investors. This often leads CEFs to utilize long-term capital gains as a source of these managed distribution payments. As a result, these CEFs will apply (and receive) an exemption to section 19a-1 of the Investment Company Act of 1940, which states that investment companies may only distribute long-term capital gains once every twelve (12) months. This exemption provides CEFs with extra resources to make good on the promises of their Managed Distribution Policies.
However, sometimes capital gains aren't enough to cover these payments, forcing CEFs to return capital (referred to as a Return-of-Capital ((NYSE:ROC))) to investors. This aspect is often overlooked due to the high and consistent yields offered by CEFs with Managed Distribution Policies.
With this in mind, GrowthIncome decided to take a deeper look into CEFs that operate under a Managed Distribution Policy in order to see how these distribution payments are being made, and how they affect a fund's underlying assets and its performance.
Unfortunately, the facts have negative implications for investors.
"Managed Distribution Policy": Of the 592 CEFs that we follow, 77 have instituted a "Managed Distribution Policy" on March 31, 2014. For further study, we placed each of the 77 CEFs into one of four categories based on their current premium/discount: 1) CEFs trading at a premium to NAV; 2) CEFs trading at a discount between 0 and 4.3% to NAV; 3) CEFs trading at a discount between 4.3% and 8.3% to NAV; and 4) CEFs trading at a discount between 8.3% and 12.6% to NAV.
Surprise, Surprise! Below is a chart showing the percentage breakdown of each category's distribution sources (net investment income ((NYSEMKT:NII)), long-term capital gains, short-term capital gains and return of capital.
Numbers Don't Lie: As the chart shows, for CEFs operating under a Managed Distribution policy, there is a clear correlation between a fund's return of capital and their current premium/discount: the higher the premium, the higher the Return of Capital. We find this correlation to be quite odd as a return-of-capital does not necessarily reflect the CEF's investment performance. It should also not be confused with "yield" or "income." The return-of-capital is a net decline for a fund's NAV share price, even if there is no net investment income, no capital gains and no change in the share price.
In addition, the percentage of Net Investment Income as a source of distribution drops as premiums rise. There is also a similar relationship between long-term-capital gains and premiums.
Not the Way the Game Works: Net investment income plus capital gains is how price appreciation should work. In these circumstances, it is a Return of Capital that is depreciating NAV while the stock price remains unchanged, resulting in a premium and a distortion of value.
Premiums: Currently Cornerstone Advisors, Inc. manages three (3) CEFs: Cornerstone Progressive Return (NYSEMKT:CFP), Cornerstone Total Return (NYSEMKT:CRF) and Cornerstone Strategic Value (NYSEMKT:CLM). These are the only funds they manage. Each of these funds operates under a Managed Distribution Policy with premiums of 24%, 20% and 17% respectively.
Aberdeen also manages two funds trading at premiums with Managed Distribution Policies: Aberdeen Chile Fund (NYSEMKT:CH) and Aberdeen Australia Equity Fund (NYSEMKT:IAF). However, the Aberdeen Singapore Fund (NYSE:SGF) has a Managed Distribution Policy with a -11.4% discount.
The CEFs and Their Premiums: In order to fund these Managed Distribution Policies, CEFs may rely on "right offerings" for additional capital. Under a rights offering, shareholders will receive a certain number of "rights" for each share they own. They can then use these rights to purchase additional shares issued by the CEF. This raises additional capital for the CEF to fund the continuation of their Managed Distribution Policy. In essence, shareholders are paying their own dividends. Both Cornerstone and Gabelli have done this on occasion.
Corruption in Investors, Traders, or CEFs: The investors may want to know that return-of-capital ("ROC") is not a strategy! You give them your premium dollars and they take an "expense fees" and then return it to you in the form of dividends. That is like you taking money out of your left hand pocket, giving away a portion of it in the form of a fee, and then returning the remainder to your right hand pocket and calling it a dividend.
However, investors may have caught onto this and unfortunately, it is possible that something even more disturbing is going on. Either the traders or the CEFs (or both) have formed an alliance to push the stock price higher and inflate the premium when the "right offerings" occur. This could keep the scheme going in perpetuate.
For a deeper look into a specific CEF's foray into these potential practices, check out "What's Wrong With Cornerstone Total Return Fund's Right?"
For more data on Closed-End Funds (CEFs) and the Managed Distribution policy, visit the extended article on GrowthIncome's website.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.