Return of capital: Part 2

Perhaps no other closed-end fund (CEF) issue is as vexing as return of capital, yet it is critical to understand.

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In Return of capital: Part 1, we explained why return of capital (ROC) occurs and briefly outlined the different types of ROC. In Part 2, we'll delve further into pass-through and constructive return of capital.

Pass-through return of capital

This type of return of capital is neither good nor bad. It arises from accounting conventions, primarily. CEFs that invest in master limited partnerships (MLPs) are the primary CEF distributors of pass-through ROC. Despite the pass-through ROC from MLP CEFs, the CEF structure provides beneficial tax implications compared to investing directly in an MLP. Because it is an accounting convention, we view pass-through ROC as "good" ROC.

Constructive return of capital

This arises from unrealized capital gains. A fund's total return is more important than its distribution. We do not like to see portfolio managers have to sell securities that are rising in value simply to meet a distribution.

For example, let's say a CEF is 95% invested in one security, with the other 5% sitting in cash. That security was purchased at $100, is now worth $110, and the portfolio manager believes it is worth $120. The manager could sell some of the security to pay the distribution, which would then be attributed to a capital gain, in the distribution estimate. Or the fund could meet its distribution commitment from the 5% of cash it has, but the distribution would be attributed to return of capital.

Which would you rather have happen?

We would prefer to see the portfolio manager stick to the investment strategy, allow the security scenario to play out, and have the fund make a return of capital distribution. By year's end, it is possible that the capital gain will have been realized at $120, and the actual (not the estimated) source of the distribution would then be a realized capital gain.

How can you tell if a return of capital was constructive? A fund's net asset value is composed of the following:

  • Cash on hand
  • The portfolio securities' cost basis
  • Subsequent investment income
  • Subsequent realized capital gains/losses
  • Subsequent unrealized capital gains/losses

If a CEF has estimated that a distribution came fully or partially from return of capital, then the sources must be either:

  • Cash on hand
  • Subsequent unrealized capital gains/losses

Furthermore, every distribution—regardless of its source—is deducted from the NAV. So, if a CEF's NAV plus its distribution increases over a period, then any distribution attributed to return of capital is actually a constructive use of return of capital.

Here's an example:

  • NAV at beginning of period = $10.00
  • Distribution during period (100% estimated to be return of capital) = $1.00
  • NAV at end of period = $10.00

In this case, the fund has returned $1.00 per share out of unrealized capital gains. It has had a NAV return of 0% and a distribution rate of 10%, combining for a total return of 10%. This was constructive return of capital, and any NAV greater than the beginning NAV would also indicate a constructive use. If a CEF has a total return greater than or equal to its distribution rate, and any portion of the distribution came from return of capital, then that was constructive return of capital and is not a red flag.

See Accessing the Morningstar report for distribution information.

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