Closed End Fund Distributions, A Closer Look

| About: Nuveen Nasdaq (QQQX)
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Some closed end funds receive enormous attention because they trade at a discount and have an attractive dividend yield. This is certainly a good place to begin a closed end mutual fund search, but it requires further study to determine if it is an appropriate investment. By all means, if it looks too good to be true, then it probably is too good to be true.

Let's examine Nuveen's Equity Premium Advantage Fund (JLA). The price of JLA trades at a 12% discount to its net asset value, and it shows an annual distribution yield of 9.5%.

At first glance, JLA seems similar in construction to the Nasdaq 100 Index since the top 10 holdings are very similar. An investor writing June at-the-money call options on PowerShares QQQ Trust (NASDAQ:QQQ), the exchange traded fund, can generate an annual options yield of about 15%, and this ETF pays a dividend of 0.75%. On April 26, QQQ was quoted at $66.73, and June calls struck at $67 were bid at $1.42. An investor writing calls over the course of a year, assuming prices and volatility remain constant, is able to generate a 15.75% yield. The risk to this covered call writing strategy is that if the underlying were to rise in price beyond $67, then the holder does not enjoy price appreciation beyond $67.

Taking this second look of reconstructing JLA from the perspective of QQQ would make it seem that the distribution yield resembles what a covered call strategy on an equity portfolio would achieve. However, the JLA fund holdings as of February 2012 shows covered calls written on equity indices which total only 5.3% of the portfolio.

Reconstructing the distribution of JLA to represent 5.3% of a 15% options yield only creates 0.8%, but add the dividend of 0.75% to get a net 1.55%. There is a disconnect between the 9.5% annual distribution yield on JLA and what would be achieved by writing monthly covered calls on QQQ. The difference, 7.95% of the distribution, is due to distributing capital, realized gains and dividends in the form of a distribution to shareholders.

The December 2011 Annual Report for JLA shows that there was $7.4 million of options premium written on $352 million of assets, and dividends totaled $6.2 million. The remainder of the distribution comes from realized gains $8.4 million and return of capital $8.9 million. Thus, 3.86% of the return is from option premium and dividends, and 4.91% is from realized gains and a return of shareholder capital. Nearly 30% of the distribution comes from a return of the stockholder's own money.

The point we seek to drive home is to take closer notice of where the distribution return comes from. While we feel that Nuveen is an impressive management company, it appears that accounting policy has compromised the value of this specific investment product.

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