Closed-End Fund Return Of Capital: Good, Bad, Or Other

Includes: EOI
by: Reuben Gregg Brewer

Return of capital is a contentious issue with CEFs.

It's also a confusing and sometimes misunderstood issue.

In truth, return of capital can be either good or bad, depending on other factors.

Eaton Vance Equity Income Fund (NYSE:EOI) buys stocks and writes covered calls. The goal is income. In fiscal 2014 (its years end in September) it paid a distribution of $1.04 a share. Nearly 25% of that was return of capital, or ROC, an increase from zero return of capital in fiscal 2013. That's bad, right? Maybe not.

What is return of capital?
When you get down to it, return of capital is more of an accounting identity then an actual thing. It's kind of nebulous in some ways. I say that because the other two sources of money for distributions are fairly straightforward. Income is dividend or interest payments received by the fund. Capital gains come from the profits in the fund's trading activities. Other stuff, well... that's not so clear.

What is other stuff? In the case of EOI, the other stuff is largely income generated by the sale of options. This isn't dividend or interest income and it isn't capital gains, so it gets dumped into return of capital. But the net asset value, or NAV, of EOI went from $13.38 a share at the end of fiscal 2013 to $14.60 at the end of 2014. So while 25% of its distribution in the year was counted as return of capital, it certainly wasn't "destructive."

If you are looking for an easy rule of thumb, if a fund's NAV is going up even though it has return of capital in its distributions, ROC probably isn't doing any harm. In fact, return of capital in this situation might actually be helping you because it reduces the income taxes you have to pay on the fund's distributions (though ROC also reduce your cost basis, which can mean more capital gains taxes later). Put another way, in fiscal 2013 when EOI had no return of capital shareholders had to pay more income tax on the distributions they received.

When it's bad
I put the word "destructive" in quotes above because destructive return of capital is the big fear. You don't want to own a fund that is basically paying you back your investment over time. That's a fund that is, essentially, slowly liquidating itself. EOI can be used an example, here, too.

In fiscal 2011, the fund's NAV fell from $12.87 a share to $11.15. All of its distributions in that year were return of capital. This is an example of destructive return of capital, since the fund's NAV dropped. A fund can't keep paying out big distributions while its NAV falls, eventually there will be nothing left in the fund.

Over a year or two this may be acceptable because of market activity. Indeed, if you are trying to live off of the income your portfolio generates, you may appreciate a fund maintaining its payment level in turbulent markets despite the ROC issue. If you were managing your own money, you might have chosen to dip into capital, too, to support your spending. However, more than a couple of years and you'll need to seriously think about whether or not you still want to own the fund.

That said, when ROC and a falling NAV are happening at the same time, you'll want to keep an eye out for distribution changes. EOI, for example, cut its distribution in 2011 and again in 2012. Basically, it was obvious that the dividend wasn't sustainable so management did something about it. The results? The fund's NAV went up in fiscal 2012, 2013, and 2014. To be sure, the stock market had something to do with that, but trimming the distribution certainly didn't hurt any.

Still more confusion
There's another wrinkle with ROC, too. And that's capital losses. If a fund can offset its capital gains with capital losses, it still has the money to distribute, but it's no longer a capital gain. That means, you guessed it, ROC. Those offsetting losses could have occurred during the same year or during a recent previous year. However, that doesn't mean anything to the fund's NAV. If NAV goes up, there's no harm to ROC.

And, to make things even more confusing, some people like destructive ROC. Why would anyone like that? Well, if you buy a fund at a 20% discount to NAV and you are getting only destructive ROC distributions, they are being made at NAV -- not the 20% discount at which you bought in the open market. So every penny you get back is making you money when a fund is self-liquidating in this situation. I wouldn't suggest buying funds with this as the goal, but it is something to keep in mind if you see destructive ROC distributions. If you paid less than the NAV, the situation isn't as bad as it may appear.

Return of capital: Good or bad?
In the end, return of capital in and of itself isn't good or bad. It's just a piece of information. You need to take a broader look at what's going on with the fund. If a fund's NAV is heading higher and it's distributing ROC, no harm is being done. If the fund's NAV is falling and its distributions are made of ROC, there's a problem. But as I noted above, it's not so simple to decide what to do from there. In some cases, destructive ROC can be seen as a good thing. In others, a rising market can reverse the trend or management may decide to trim the distribution to a more manageable level, resolving the issue in a different way.

Essentially, ROC alone doesn't tell you very much. You need to look at ROC in the bigger picture to determine if you need to take action or not.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.