CEF Return of Capital: The Good and Bad

 |  About: Gabelli Dividend & Income Trust (The) (GDV)
by: The Simple Accountant

Frank Constantino's fine piece on The Gabelli Dividend and Income Trust (NYSE:GDV) brought out a good discussion in the reader comments, and a number of readers expressed reservations about the fund due to the return of capital component in the distribution. CEF investors are understandably concerned about this issue, as they don't want their capital base eroded - especially if they depend on that capital to fund their living expenses. What they should understand, however, is that all distributions of capital are not the same. There is a difference between good and bad return of capital.

How can there be "good" return of CEF capital? The answer lies in the treatment of unrealized gains in the fund. Consider the example of a fund that holds positions, which have appreciated in value, and the portfolio manager wishes to hold these positions, while at the same time distributing a portion of these gains to shareholders. Because there are no proceeds from the sale of the securities, this part of the distribution must be funded from cash reserves. At the same time, because no gains have been realized, that amount must be treated as a return of capital.

How can we tell the good from the bad? The key for investors is to look at net asset value. As a general rule, if the distributions have included return of capital, and net asset value is the same or higher than it was at the beginning of the distribution period, they have received a distribution of unrealized gains - a "good" return of capital. If on the other hand net asset value has fallen, then the distribution was a "bad" return that actually depleted the fund's capital base.

Let's use GDV as a real life example. According to CEFConnect, return of capital comprises 78.8% of the prior calendar year distribution. However, net asset value rose from $15.58 on 12/31/2009, to $17.64 on 12/31/2010. Clearly the return of capital was a distribution of unrealized capital gains. Not only was this a good return of capital, but in the short run a tax friendly one as well, as return of capital is not taxable but lowers the cost of the shareholder's basis (of course this will even out in the long run; at some point the positions are likely to be sold and gains realized, creating a taxable event).

Now we can see that the shareholder's capital base was not eroded, and the fears about this well managed fund are not entirely justified on this basis alone. If you like the Gabelli Dividend and Income Trust, and it is appropriate for your situation, go ahead and give it another look.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.