If someone start looking at the different closed end funds (CEFs) available, e.g., by using one of the freely available screeners, and rank them by the size of the yearly distributions (or dividends), two funds come immediately in the picture: the Cornerstone strategic value fund (NYSEMKT:CLM) and the Cornerstone total return fund (NYSEMKT:CRF), that have a total distribution rate (with respect to the net asset value) of 24.56% and 24.51%, respectively (data, as all data in this article based on the values provided by the screener, based on end-of-day data for Friday May 13). This article will examine if this is as good as a deal as it sounds, because who wouldn't want to have a 24.5% dividend?
1) How reasonable is the price of these funds?
Since CEFs are actively managed, in this case by Cornerstone Advisors, a yearly cost is deducted by the fund. For these funds the costs the adjusted total expense ratio is 1.31% for CLM and 1.35% for CRF.
When looking at the value of the fund, a difference should be made between the net asset value , or in simple terms the value of all holdings of the fund, and the market price, or the price you can acquire the fund. In most CEFs the market price is trading at a discount to the net asset value. However, both Cornerstone funds are trading at a premium: CLM is trading at a 11.58% premium, while CRF is trading at a larger premium of 19.26%. This immediately implies that you pay more than what the funds are actually worth.
Looking at the premium/discount for the past year shows that both funds always traded at a large premium, except for January and February of this year, where CLM was trading at a discount.
Assuming the distribution remains the same, and we open a position now, the yield with respect to the market price will be lower as we're paying a premium, but it still stands at a respectable 21.07% for CLM and 20.78% for CRF.
It is also important to note that the distribution is linked to the net asset value: once a year (end of October) the distribution amount is set based on the net asset value.
So to recap: if we own the funds, we are paying 1.3% yearly as the management fee, and if we enter now, we pay substantially more than what the fund is worth. But at least we are getting a generous yield, right?
2) Analysis of the distributions
Not so fast, let's look at the nature of the distributions in detail. The distributions, which are paid monthly, can consist of 4 different types: long-term capital gain, short-term capital gain, dividend income, and finally return of capital. The first three are related to the holdings and the trading of the fund itself, and while they can have different tax consequences, which I will not discuss here, we can call these "good" distributions. Return of capital on the other hand, means exactly what the name implies: you're getting back your own money. Therefore this is also the kind of return you want to avoid: you don't want to pay a fund 1.3% a year just to get your own money back!
That being said, let's have a look at the nature of the recent distributions.
As can be seen from the pie charts, 78% of the distributions for CLM and 87% for CRF is return of capital! To add a, very irrelevant, but positive note: there is almost no short-term capital gains (the one that is taxed the most in a non-tax deferred account.
Giving that the funds are returning your own money at a rapid rate, the net value of the funds also decreases at a quick rate: the net asset value also decreased over the last years (net asset value taken at the time of the distributions)
How is this sustainable? The short answer is: it is not.
Despite that the funds have been around since 1987 and 1973 . The reason for this longevity is that the funds issue from time to time different rights offerings: these offerings give existing share holders the "opportunity" to buy more (newly issued) shares. The additional fund income then increases the net asset value, so that it can be used to distribute this money again back to you...
This decrease in net asset value also implies that the distribution per share will decrease every year.
So to recap: most of the distribution is actually your own money, and as a result, the net value of the fund decreases over time. To only method to avoid this decrease (and keep the distributions flowing) are rights offerings from time to time. The decrease in net asset value will also decrease future distributions.
3) If you own shares: use the dividend reinvestment plan
By now it is probably clear that, according to me, investing in these funds is not a prudent thing to do. Nevertheless, if you disagree with the drawbacks I just described, there is something you should be aware of, and that is the dividend reinvestment plan. On the website of the funds (CLM or CRF) you can find the rules for this plan, and I quote:
The method for determining the number of Newly Issued Shares received when Distributions are reinvested will be determined by dividing the amount of the Distribution either by the Fund's last reported net asset value per share or by a price equal to the average closing price of the Fund over the five trading days preceding the payment date of the Distribution, whichever is lower.
So if the funds are trading at a premium over the net asset value, you will receive shares at the net asset value. This means that, if you immediately sell at the open market, you gain an immediate (short-term) profit equal to the premium (so 11 or 19% based on the latest numbers).
Investing in these funds means that investors pay a 1.3% yearly fee and a hefty premium over the net asset value of the funds, so that they can get there own money returned slowly over time. The rate of this return will decrease with decreasing net asset value. The only reason these funds still exist is that from time to time investors buy more shares of them. As soon as this influx of money stops, the funds value will decrease and go to zero, and people might get returned less money than they invested. If you have shares and want -for some reason- keep them, be sure to use the dividend reinvestment plan.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: All data used in this article are based on the Friday May 13 end-of-day data, freely available from the Fidelity CEF screener. I generated all images based on this data.