Preface: The following is a letter to the SEC regarding the CEF Managed Distribution Programs as being potentially misleading for retail investors and contributing to mis-valuation of the securities as well as enabling certain CEF managers to potentially manipulate CEF share prices.
Conclusion: Managed Distribution Programs (“MDP”), as currently constituted, should be eliminated or reporting standards significantly modified. MDPs tend to cause an estimated average stock price to be overvalued by 23% for CEFs that employ an MDP versus those that do not based on nominal relative reported distribution yields.
The Issue: Under the Investment Company Act of 1940, Section 19(b), a CEF is limited to one distribution per year of its long-term capital gains. A CEF can apply for an exemption from the SEC allowing a CEF to make a periodic level distribution composed of net investment income, capital gains and a return-of-capital (“ROC) during the year.
The Problem: It is the combination of both earnings and ROC being calculated as a single nominal yield by financial reporting services—as well as the CEF in its reported literature—that is misleading for investors and tends to support inefficient stock valuation for this stock market sector.
“Sucker Punch” for Retail Investors: Retail investors seeking an attractive yield often mistakenly interpret the nominal yield from a CEF that employs an MDP as reflective of its profitability (return-on-investment). In the case where a portion of the CEF’s distribution is ROC, the nominal yield does not reflect return-on-investment. As a result, investors may be unaware that a portion of that yield is just a return of their own capital. As a consequence, such investors tend to overvalue such stocks based on that misconception.
Another Arm Tied: Further handicapping prospective investors is the disclosure of the return-of-capital component of the distribution is not required to be a widely disseminated public disclosure. The only requirement of the distribution composition is a Section 19(a) filing under the ’40 Act. Such a notice is required to be provided to existing shareholders. So, prospective shareholders are flying without radar. (In all fairness, certain CEFs do post their Section 19(a) on their websites, but provide little educational value.)
An Incredibly Simple Solution: One simple way to eliminate the distortion and mis-pricing caused by MDPs is: Do not allow any return-of-capital component to be calculated as part of a CEF’s published yield. The only yield allowed to be published should be its investment yield, i.e., that portion of the distribution that is from earnings or capital gains, i.e., “return-on-investment” not “return-of-investment”!
MDP Vs Non-MDP Comparison: There are approximately 69 CEFs that employ MDP’s out of over 600. The table below is a summary of 57 CEFs that employ MDPs. (Eliminated from the calculation was the “OtherFnds” category as many members are buy/write option funds. Such funds have an inherent mismatch of GAAP earnings and “E&P” reporting which is beyond the scope of this article.)
The “Real Yield” Please: As the chart demonstrates on average only 56% (row “R”) of the MDP distributions are being derived from net investment income (“NII”). Yet the average nominal yield of CEF employing a MDP is only 1.5% greater than the CEF universe (row “D”).
Overvaluation of MDP Stock Prices: If MDP’s and non-MDP’s valuation were comparably valued, investors would ignore the ROC component of the MDP CEFs and the value both MDP and non-MDP CEFs on their respective investment yield. However, this does not seem to be the case.
Valuation Comparisons: In order to calculate a comparable valuation of a MDP and a non-MDP CEF stock price, the net investment income yields (“NII Yield”) of an MDP CEF was calculated based on reported NII (row “E”). Then an adjusted NII per share was calculated based on a constant NAV of $100 per share and related premium (row “L”).
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Assuming that approximately 20% of the nominal yield of the non-MDP was supported by sources other than NII (row “O”), the adjusted NII per share (row “L”) was divided by the estimated NII yield of the non-MDP CEFs to arrive at a estimated share price of the MDP CEF based upon its non-MDP NII Yield.
The underlying assumption is that their valuations should be similar as there is no value to a return-of-capital distribution (null hypothesis).
Results: This assumption did not prove correct. The results demonstrated on average that there is a 22.8% greater stock price valuation for MDP CEFs than that which was calculated based on non-MDP NII estimated yield.
This difference I attribute to retail investors’ misunderstanding that a portion of the MDP’s nominal yield may be a return-of-capital.
Different Overvaluation by Fund Type: The GenEqFnds overvaluation was extraordinarily high. This was as a result of the three Cornerstone funds (CLM, CRF and CFP) which generated an average premium of 47%. If the three Cornerstone funds were taken out of the GenEqFnds group, the premium/discount would drop from an average 3.1% premium to a 6.3% discount. This would place the results more in line with the other fund type categories (row “I”, GenEqFnds).
Let’s Get Small: An adjustment was made for the average trading volume of the Cornerstone funds. Any of those with the average daily trading volume above its largest traded fund was eliminated. The difference was small; the average discount was 4.6%.
Curious Valuations: Base on the numbers, either the Cornerstone funds are freaks of nature or there is something else that is causing the astronomical odds of three small CEFs trading at “out of orbit” premiums that’s not supported by their respective metrics. (I would encourage your organization to review the trading patterns of the Cornerstone funds.)
For those situations where a ROC distribution reflects unrealized capital gains, I also checked the changes in NAV YTD as a source of ROC being an unrealized capital gain distribution. On average the NAVs were down.
A Simple Tweak: A simple tweaking of how MDP yields are calculated and distributed in the financial press would go a long way in providing better visibility and more accurate relative valuations. This burden of return-on-investment discovery should be the CEFs’ management and not prospective or existing shareholders.
Caveats: There are a multitude of issues that could change the results of this analysis. One of the assumptions that 20% of non-MDP CEFs distributions came from other sources other than NII could be incorrect. At a 30% level, the overvaluation declines from 22.8% to 7.5%. The difference between taxes and GAAP could also cause a change in the underlying numbers. Also, my limited understanding of the SEC regulations may have distorted the results.
Disclosure: No positions