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Return of capital part I

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  • Closed-End Funds
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Perhaps no other closed-end fund (CEF) issue is as vexing as return of capital, yet it is critical to understand. 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, which comes in different flavors:
  • pass-through (from master limited partnership investments, primarily)
  • constructive (from unrealized capital gains)
  • destructive (investors are literally receiving their own capital, minus expenses)

Before we delve further into the types of return of capital, let's first understand why return of capital may happen. Fund families understand that it's in their benefit for their CEFs to trade near or above the NAV. They also understand that the distribution rate is a large determinant of a CEF's discount and premium.

For their part, investors themselves prefer "smooth" distributions, which occur every month or every quarter, to annual distributions. This gives them regular income payments.

To facilitate "smooth" distributions, fund families have adopted managed distribution policies. Equity funds must petition the Securities and Exchange Commission for a Rule 19(b) exemption. Rule 19(b) refers to a section of the Investment Company Act of 1940, which states "It shall be unlawful…for any registered investment company to distribute long-term capital gains… more often than once every twelve months."

Learn how to access the Distribution Policy and Payment for a CEF on Fidelity.com

Decisions must be made to successfully operate a managed distribution policy. Typically, an executive committee will forecast the portfolio's anticipated income and capital gains for the upcoming year, and make regular monthly or quarterly distributions based on that estimate. But forecasts can be wrong and estimates can be off. This is especially true in the short term. In any given period, a fund may not have generated enough income or capital gains to meet the distribution. So, in this case, some of the distribution may be made up of return of capital.

Throughout the calendar year, funds estimate the breakdown of their distributions, but these are only estimates. In January, shareholders receive a Form 1099-DIV with the actual distribution breakdown for the prior year for tax purposes. If you see return of capital was employed at your fund, this isn't necessarily bad news. Although investors should avoid funds with consistent use of destructive return of capital, to dismiss a CEF from investment consideration simply because it has distributed return of capital is unwise.

First, it could be that the fund is simply passing through return of capital from its underlying holdings. This is true for funds that invest in master limited partnerships, which themselves distribute return of capital to their own shareholders. One CEF, Cohen & Steers Closed-End Opportunity (FOF), invests in CEFs that may return capital, and this fund--in turn--passes that onto its shareholders.

Second, a fund may have unrealized capital gains in the portfolio, and the portfolio manager doesn't want to sell a holding just to meet a distribution commitment. This is constructive return of capital because the portfolio manager is, theoretically at least, continuing to invest for a fund's total return, instead of just for a distribution rate.

In a third scenario, a fund may have hit a rough patch, but the board of directors doesn't want to reduce the distribution. Distribution reductions typically result in a share price decline, so directors are usually averse to reducing them unless there is a clear and compelling reason to do so. This is why we don't lambaste a fund for using destructive return of capital infrequently. Before year-end, this return of capital estimate may be erased and not even show up on the 1099-DIV form. However, consistent use of destructive return of capital is a huge red flag, especially if the return of capital comprises the bulk of a distribution.

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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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