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Return of capital (ROC) is a term used by sponsors of high yielding Closed-End funds (CEFs) to describe that portion of any distribution that is not designated as either ordinary (investment) income or realized capital gains. In other words, fund sponsors of equity CEFs try to predict how much their funds should earn each year and set their monthly or quarterly distributions based on that expectation. Any part of a distribution that does not come from either of those two sources, (1) ordinary income from portfolio dividends and interest, or (2), realized capital gains is designated as Return of Capital (ROC).

Though it sounds like ROC is just the fund returning that portion of your investment which is not "earned" and thus comes at the expense of the fund's Net Asset Value (NAV), there's a lot more to it than that. Take, for example, a fund which has only one equity position and that one position rose 100% in a single year. Let's say the fund also bought leap put options to protect the downside since it wouldn't be very prudent for the fund manager to be so concentrated in one position without some protection, right?

Let's say the fund paid an annualized 10% quarterly distribution as well. Since there were no earnings from the fund (let's assume it was a high-flying tech stock) and there were no capital gains taken other than the loss on the options position, the entire 10% distribution would be considered ROC because it was assumed to come from unrealized capital gains or realized losses. So a fund that included a 10% distribution yield that was all ROC and suffered a realized loss of 15% in its leap options (which can be used to offset future realized gains) had a total return of 85% for the year (100% unrealized gain - 15% realized loss). Not bad ... but according to many investors and analysts alike, that 100% ROC would have been a huge red flag and many investors would not have touched this fund with a 10-foot pole.

The point I'm trying to make is that funds with high ROC in their distributions need to be further analyzed as to where the high ROC is coming from before one makes a judgment call on the merits of the fund. Many funds may be doing quite well and growing their NAVs even with high ROC in their distributions. In fact, many funds try to maximize ROC because of the tax benefits.

Consider the Gabelli Utility Trust (NYSE:GUT) fund. Here's a fund trading at a 40% premium over its NAV, the fourth highest of all CEFs, and yet most of its distributions since 2008 have been about 80% to 90% ROC. Did anybody care that this fund had such a high ROC for much of the past four years? Apparently not. Only in the last several months has GUT's distributions shifted back to ordinary (investment) income and away from ROC as the fund appears to have used up any remaining capital losses.

Yet even with that high ROC for most of the year, GUT's NAV is up about 10% YTD due to a leveraged portfolio of domestic utility stocks which have enjoyed a strong utility sector this year. So why are investors willing to bid up GUT to a 40% premium with high ROC even though it cut its distribution over the past year like a lot of other funds and has a relatively low 8.3% distribution yield? Is it because of a strong utility sector and a perception of safety in utility stocks? Maybe, but GUT also uses leverage which can dramatically increase volatility in the fund even for utility stocks. I certainly wouldn't recommend anyone pay $7.45 for a leveraged fund whose liquidation value is only $5.34 but I think its interesting that high ROC has never been a deterrent for investors in GUT.

The real question is why some funds with high ROC are immediately disregarded by investors and funds like GUT are not. I could rattle off a dozen option-income funds that also have NAVs which are outperforming the broader market this year but have drifted to -10% to -15% discounts instead of 40% premiums. Even if option-income funds won't offer the NAV upside of a leveraged fund, why are they not getting the benefit of the doubt when they are also outperforming and with significantly higher yields in the 10% to 12% range?

Option-income funds tend to have large ROC percentages because they also have low turnover and don't rely on ordinary (investment) income to help pay for their large distributions. As a result of their option writing, there is very little incentive for the fund to take realized capital gains in their stock positions but there is usually opportunity to take realized losses no matter what the broader market is doing.

In an up market, the fund could close out options at a loss or it could allow the options to be exercised resulting in a gain. Most fund managers opt for closing out options during an up market period and taking the loss so that it can be used as ROC as part of the distribution. In a flat or down market, the fund is realizing capital gains in its options but may be able to offset those gains by taking losses in their stock positions or offsetting against realized loss carryover. Again, this may result in part or all of the distribution being designated as ROC.

This is, frankly, exactly what is going on with many option-income funds. Though their option strategy has worked well this year and the funds have realized substantial gains in their option writing, many of these funds have built up option losses from the ramp-up market from 2009 through 2010 that they are working off and so high ROC levels may continue in these funds for some time. That does not mean, however, that this is "destructive" ROC in their distributions as analysts from Morningstar like to describe funds which are just making distributions at the expense of the NAV. "Destructive" ROC results when a CEF's income strategy is not working or is not optimized and the fund has to resort to paying its distributions from NAV capital instead of its income. This may have been the case in 2009 and 2010, but many of these option-income funds adapted by reducing their distributions and are now doing much better in 2011.

For 2011, many option-income funds have been able to use this volatile, up and down market environment to their benefit and have been able to realize significant option writing income as a result. Unless we go back to a ramp-up market like in 2009 or 2010, this should continue for many funds, even those with high ROC in their distributions. But as we've seen from a fund like GUT, that doesn't necessarily have to be a bad thing.

Source: Can A High Return Of Capital CEF Trade At A 40% Premium?