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Return of capital (ROC) seems to be one of the most hotly debated issues concerning closed-end funds (CEFs) and their dividends. Just this past weekend, Barron's featured an article titled "Don't be fooled by Yield on Closed-End funds" which mentioned some funds having overly large return of capital percentages. I have even seen analyst reports which seem to rate closed-end funds by the amount of ROC in their distributions. So if it’s controversial for analysts, then I’m sure it’s controversial for a lot of individual investors.

Because of their investment strategies, many CEF distributions, particularly from the option-income funds, can include a large percentage of return of capital, upwards of 95% for each distribution. But is that as bad as it sounds? Many investors, and even analysts, believe that return of capital is just returning your investment back to you. Sort of like if you went out to the movies and saw “Return of the Vampire” or “Return of the Living Dead,” you would probably expect to see a horror film and you could probably expect to be scared. If only "return of capital" was so simple.

Return of capital results when a portion of a distribution to shareholders is something other than earned income or realized capital gains. Earned income comes from portfolio dividends and interest while realized capital gains come from securities sold which have appreciated above their adjusted cost basis. ETF's and mutual funds distribute their actual earned income in the form of dividends and their net realized capital gains in the form of year-end distributions typically. Both are taxable events for taxable accounts and the funds are reduced by the amount of the distributions. CEFs also distribute their earned income and realized capital gains in their recurring dividends and sometimes in a year-end distribution as well, but the difference is that CEFs project what the income level will be for the fund over time and set their recurring dividend based on that amount. So any part of the distribution that is not earned income or realized capital gain is called return of capital.

Hmm, so far it sounds like CEFs really are just returning your investment. But this is where it gets complicated. Many CEFs rely on high earned income and even appreciation, i.e. realized capital gains, to cover their dividend. Leveraged strategy and dividend harvest strategy CEFs fall into this category and the result can be a lower ROC component. The one CEF strategy that doesn't place a reliance on earned income or portfolio appreciation to pay their dividends are the option-income funds. Instead of my attempting to explain how option-income CEFs work and why they have such a high return of capital component, this release from Eaton Vance dated July '09, which any investor can access from their website, explains it best.

Eaton Vance Option Income Closed-End Funds

Nondividend Distributions – Return of Capital

Unlike a fixed-income fund, equity income fund earnings in a particular payment period will generally not match a fund’s distribution for that period due to the nature of equity securities. Fund managers may determine an appropriate level of distribution based on what they believe is the long-term projected performance of a fund.

The tax character of these distributions can be affected by many factors such as: Dividends received on the funds’ stock portfolios; the net option cash flows the funds receive; the stock market price behavior during the year; portfolio turnover; and differences between the market’s actual returns that year and its expected performance over time.

The funds’ strategies involve selling index call options and/or call options on individual stocks. If an index rises, the fund’s net return on its index options positions may decline (and can be negative in sharply rising markets). The “hedge” that these funds provide is that a decline in option value may be offset by price gains (capital appreciation) on the fund’s underlying stock holdings. The opposite applies in a declining market where some of the stock price decline may be offset by gains from the writing of call options.

These examples are based on a fund writing a 30-day index option that is 1% out of the money; that is, the exercise price of the option is below the current level of the applicable index at the time the option is written.

1. Strongly Rising Market

In a strongly rising market, the fund will likely be “losing” on its options strategy because the market could move higher than 1% in a month. The fund would be required either to settle its option obligation in cash at expiration or to buy back that option with cash prior to that date. However, in that environment, the stocks in the underlying portfolio of the fund are likely gaining value and, because these are index options settled for cash, no stocks are called away to settle the options. Pursuant to the funds’ investment strategy, under these circumstances, the fund may pay its distribution from the unrealized gains in the underlying stock portfolio; however, this is deemed to be a return of capital for tax purposes.

2. Sharply Falling Market

In a sharply declining market a fund writing 30-day index options that are generally 1% out of the money will likely be “winning” on its options strategy; the options are never exercised and the fund retains the option premium from writing the options. However, the underlying stocks in the fund are likely declining in value; there may be realized and unrealized losses generated on these stocks. The fund may be earning significant realized gains in its options strategy in this environment, which can be used toward paying its distribution; however, as part of the tax-management strategy, the fund is also likely intentionally realizing losses on certain stocks in the underlying portfolio, which when offset against the gains in options, may cause the distribution to be classified as partially a return of capital.

The funds' option strategies may result in a Return of Capital even when the return of the funds' portfolios is equal to or greater than the funds' distributions

A return of capital designation applies to distributions made in excess of the funds’ earnings on invested assets. These earnings consist of dividends, interest received and net realized gains to the funds. Unrealized gains in the portfolio contribute to the funds’ return on assets but not to earnings. Distributions that are made in excess of earnings are considered to be return of capital regardless of the fact that this excess amount is met or exceeded by unrealized gains in the funds.

Eaton Vance believes that in tax-managed portfolios such as these, the ability of the funds to pay a portion of the distribution in the form of a return of capital can be beneficial to the shareholders of the fund in terms of the overall taxability of the funds’ distributions. The amounts are non-taxable in the current period though shareholders are required to adjust their cost basis in the funds’ shares to reflect this distribution. Where the return of capital reflects unrealized portfolio gains, as described above, this enables the individual to defer payment of taxes on the gains until fund shares are sold.

The final composition and tax treatment of the funds’ distributions cannot be determined with certainty until after-year end results are finalized and reported to shareholders in the 1099-DIV at that time.

There is no certainty that the methods described herein will be realized in the fund now or in the future.

Two sentences should be emphasized:

"The fund's option strategies may result in a return of capital even when the return of the funds’ portfolios is equal to or greater than the funds’ distributions"

What this essentially says is that even if a fund is earning enough option premium to cover the fund's dividend, the fund manager could still designate part of it as return of capital in a falling market by realizing losses in the fund's stock portfolio. Because the option-income funds NAV's outperform in trendless to down markets, they are in a unique position to take advantage of realized stock losses in this manner. In an appreciating market, the fund may be losing in its option strategy by realizing losses (by settling or closing out option positions in cash) but has little incentive to take realized gains to offset these losses (unless stock is called away) since the continued option writing strategy will provide a downside buffer to the portfolio going forward. Thus, the distribution again can be mostly return of capital because it comes from unrealized stock gains in the portfolio. This is why option-income CEFs have such a high return of capital compared to other CEF income strategies and in fact, fund managers will even try to take advantage of ROC when they can.

"Eaton Vance believes that in tax-managed portfolios such as these, the ability of the funds to pay a portion of the distribution in the form of a return of capital can be beneficial to the shareholders of the fund in terms of the overall taxability of the funds’ distributions."

So instead of letting option premium become a short term capital gain during a down market period, which would just increase the taxable portion of the distribution, Eaton Vance fund managers actively look to take realized stock losses so that the distributions can be partially designated return of capital. The advantage of ROC is that it is non-taxable in the period received though an investor would be required to reduce their cost basis by the amount, thereby deferring tax payment until the security is sold.

If return of capital can be advantageous to an investor then why don't other CEFs try and increase their return of capital? Unfortunately, their income strategies limit their ability to do this. For the leveraged CEFs, in an appreciating market there may not be many opportunities to take realized losses to offset capital gains. In a depreciating market, the leveraged CEFs will have a higher return of capital percentage but it will still be less than the option-income funds because the leveraged CEFs rely much more on earned income, i.e. portfolio dividends and interest. Dividend harvest CEFs always have very little return of capital percentages because their dividends are virtually all earned income and earned income cannot be offset. So if return of capital is such a red flag for CEFs, then why do the dividend harvest funds such as AGD, AOD and FAV with virtually no return of capital, have some of the worst NAV performances since inception even after the past 22 months of a mostly up market?

My purpose in this article is to try and clear up some misconceptions about what return of capital is and that for option-income CEFs, a high percentage of ROC does not necessarily mean that it is to the detriment of the NAV. Finally, I don’t profess to be a tax-advisor and any tax related information in this article should be weighed against each individuals own tax situation and advice from a tax professional.

Disclosure: I am long ETV, ETW, EXG, EOS, ETY, ETJ, JLA.

Source: CEFs and Return of Capital: Is It as Bad as It Sounds?