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Closed-end fund distributions

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Except for a handful of exceptions, CEFs themselves do not pay taxes. Instead, like open-end mutual funds and ETFs, CEFs pass the tax consequences of their investments onto their shareholders. To maintain tax-free status, a CEF must pass onto shareholders, generally speaking, roughly:

  • 90% or more of net investment income from dividends and interest payments
  • 98% or more of net realized capital gains

Investors should be aware of the source of their distributions. CEF distributions have four potential sources:

  1. Interest payments on fixed-income portfolio holdings
  2. Dividends from equity holdings
  3. Realized capital gains
  4. Return of capital:
  • pass-through (from master limited partnership investments, primarily)
  • constructive (from unrealized capital gains)
  • destructive (investors are literally receiving their own capital, minus expenses)

For accounting and tax purposes, distributions must be linked back to the initial source: usually dividends, income, and/or realized capital gains. These are actual cash inflows into the fund. When the distribution exceeds the cash generated from these sources, the fund must ascribe the initial source as a return of capital. Throughout the calendar year, funds estimate the breakdown of their distributions. Shareholders receive a Form 1099-DIV in January with the actual distribution breakdown for the prior year for tax purposes. Any previous information regarding the categorization of distributions are only estimates.

Prospective investors are at a disadvantage because they do not have access to the tax forms. They must wait until the fund files its annual statement to see the finalized distribution breakdowns in order to discern its use (if any) of return of capital. Fidelity.com displays a fund's most recent distributions, along with their sources, as well as distributions for nine quarters.

Imprecise language obfuscates the source of distributions. Just as one wouldn't say a bond pays a dividend or a stock pays a coupon, investors shouldn't say that CEFs have a yield or pay a dividend.

Referring to distributions as "Yield":

  • Comes from a fixed-income investing mindset.
  • Successful CEF investors have a CEF mindset.
  • Ignores the potential other sources of the distribution.
  • Is only correct when a fixed-income portfolio distributes nothing other than the interest payments it receives on its portfolio holdings or when referring to a dividend yield, as mentioned next.

Referring to distributions as "Dividends":

  • Comes from an equity investing mindset.
  • Does not acknowledge the other sources of the distribution.
  • Is only correct when an equity portfolio distributes nothing other than the dividends it receives on its portfolio holdings. It is rarely correct to refer to an equity CEF's "dividend" payment, as equity CEFs typically also distribute capital gains.

An easy way to separate a CEF pundit from a CEF professional is to listen to whether they refer to "yield," "dividends," or "distribution rate."

Why is it important to understand the source of distributions and to use precise language?

First are the tax implications: Net investment income, capital gains, and return of capital are treated far differently under the U.S. tax code. Secondly, the source of the distribution is important in understanding the likely sustainability of that distribution:

  • Distributions primarily from net investment income are considered relatively safe.
  • Distributions from capital gains are considered suspect, as there is no guarantee that the portfolio can generate such capital gains in the future.
  • This same reasoning also makes distributions from constructive return of capital suspect.
  • Distributions from destructive return of capital are not only economically bogus, but if they are consistently used, they are also predictive of future distribution reductions.

Learn how to locate CEFs distribution information on Fidelity.com

Key takeaways

CEFs have distributions, not yields or dividends:

  • A CEF portfolio's yield may contribute to the distribution.
  • Dividends received in the CEF portfolio may contribute to the distribution.

It is important that investors understand the source of their CEF's distribution. Many unwitting investors pay extreme premium prices for CEFs that have large distribution rates derived almost solely from destructive return of capital.

There are four sources of CEF distributions:

  1. Interest payments on fixed-income portfolio holdings
  2. Dividends from equity holdings
  3. Realized capital gains
  4. Return of capital:
  • pass-through (from master limited partnership investments, primarily)
  • constructive (from unrealized capital gains)
  • destructive (investors are literally receiving their own capital, minus expenses)
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©2012 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Article copyright 2012 by Morningstar, Inc. Reprinted with permission from Morningstar, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Closed end funds may trade at a discount (or premium) to their NAV and are subject to the market fluctuations of their underlying investments. Shares of closed end funds frequently trade at a market price that is a discount to their NAV. Closed end funds are subject to management fees and other expenses.

The Closed End Fund Screener may include closed end funds not registered under the Investment Company Act of 1940

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