The Most Common Mistake CEF Investors Make

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Includes: PDI
by: Michael Foster Financial Services

Summary

Closed-end funds (CEFs) offer strong income streams and often provide superior returns.

Despite their growing popularity, many misconceptions remain common about CEFs.

The most common error about CEFs relates to return of capital (ROC), and this mistake leads many investors to make bad decisions when buying CEFs.

The most common mistake closed-end fund (CEF) investors make is misunderstanding "return of capital", or "ROC."

Return of capital is often characterized as a destructive drag on fund returns; the most visceral descriptions of ROC claim it's a trick used by shady fund managers who take investors' money and then return it back to them after taking out fees.

A Tax Term Unrelated to Returns

In reality, ROC is a tax concept. As defined by the IRS, ROC is:

Distributions that qualify as a return of capital aren't dividends. A return of capital is a return of some or all of your investment in the stock of the company. A return of capital reduces the adjusted cost basis of your stock.

As with all things tax related, ROC is a complex and opaque idea that can be used to lower tax rates for individuals and corporations. In practice, CEF managers can do something somewhat similar to tax loss harvesting to offset capital gains that it returns to shareholders.

An Example

Consider this example: Fund A has a NAV of $11.00 per share at the end of the year after starting with a NAV of $10.00 at the start of the year. Fund A owned Stock AAA which went from $1 to $3 in market price in 2017 while also owning Stock BBB which went from $2 to $1 in 2017. Everything else stayed constant.

Tracking the fund's balance sheet by the end of 2017, the fund looks like this:

Fund A Balance Sheet

Jan Yr 1

Dec Yr 1

AAA

$1

$3

BBB

$2

$1

All else

$7

$7

TOTAL NAV

$10

$11

Capital Gain

$1

Now, let's say the fund is going to pay out a 10% dividend, or $1. The fund could sell 33% of its AAA and give that income to shareholders, in which case it would be classified as short-term capital gains and taxed accordingly. Alternatively, it could sell $1 worth of BBB shares and use that to fund its dividend. That would be classified as a return of capital.

ROC = Often A Good Thing

This is an extremely oversimplified example. In reality, funds have much larger portfolios with more complex allocations. Even funds that aren't particularly tax advantaged will (if they're well managed), reorganize its portfolio both to maximize return of capital ratios and to maximize overall returns. Sometimes these objectives clash; sometimes they coincide. Good fund managers will trade accordingly.

For this reason, CEF investors should not worry about return of capital as inherently destructive, and instead, particularly with equity funds, see it as a very good thing-fund managers are trying to lower your tax burden.

Data and Classification Issues

Of course, that doesn't mean all CEFs use return of capital for tax purposes, and the worst offenders will use ROC to prop up dividends that are not being paid for with intrinsic portfolio growth and net investment income. This is why measuring the CAGR of a fund's NAV and its NII over various time horizons is essential in assessing whether the CEF is worth buying. In short, looking only at ROC, especially as reported on a website like CEF Connect (which, in my experience, often has extremely inaccurate data), will lead investors to make bad decisions.

One other significant consideration for investors: income from options and some derivatives is classified as capital gains for tax purposes, which is why buy-write funds tend to have high ROC. It's also why ROC is an almost worthless metric when assessing buy-write funds and many equity funds that also use options.

To Learn More

For more reading, investors should read this PDF by Eaton Vance and this PDF by Nuveen. CEF Insider also discusses ROC as well as how to think about NAV and NII in a special report.

An Example of ROC

To demonstrate how ROC can be misleading, let's compare two snapshots of the PIMCO Dynamic Income Fund (PDI). In October 2015, PDI had a YTD distribution coverage ratio of 157%:

In July 2017, however, that YTD coverate ratio was just 65.8%:

At first glance, it seems that PDI's dividend was safe in 2015 and is very unsafe in 2017. In fact, several articles on Seeking Alpha have hinted at this in recent months.

However, the best of those articles also point out that the fund's NAV has been growing substantially as of late:

At the same time, back in 2015, the fund's NAV was actually falling quite significantly:

You might wonder if there is an inverse correlation between dividend coverage and NAV. In the case of PDI, a bond fund, there is. Higher income will come with falling bond prices and vice versa, so it's unsurprising to see this dynamic.

It also means that PDI's fund managers have a different headache now than in 2015. Back then, they had to worry about keeping the NAV from dropping so that they'd have more capital to invest with in the future, thus keeping the dividend sustainable. Now, they have to worry about liquidating capital gains in a tax efficient way to fund dividends. Neither is inherently better or worse than the other-they're financially fundamentally different issues, and neither is really apparent by looking at ROC on its own without understanding the broader context.

Conclusion

Return of capital is a tax concept and not a financial or economic one. It is not a sufficient barometer on its own to a fund's future performance or its dividend sustainability. Furthermore, much public data on ROC is inaccurate. Investors need to operate with great care and take into consideration more than just ROC when deciding which CEF is right for them.

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.