Total return vs. distribution rate

Key takeaways

Often, income-seeking investors become enamored with a CEF's distribution rate. They lose sight of the share price return. Chasing after exceptionally high distribution rates is one sure path to CEF investment disappointment. As pointed out, a high distribution rate can be accompanied by a declining share price return.

If a CEF's distribution rate looks too good to be true, it is. Note that we didn't write "it might be" too good to be true. It is too good to be true. By keeping your eye on the total return, you will not get suckered into purchasing a CEF with a high distribution rate and a declining share price return.

Total return is most important

Many income-seeking investors are drawn to closed-end funds (CEFs) because of their relatively high distribution rates. Because CEFs have closed-end structures, their capital is relatively stable. This allows them to invest in riskier assets, which typically pay relatively high yields, and to use leverage, which can boost the portfolio's income on a NAV basis.

The average CEF has a distribution rate of more than 6% of net asset value (NAV). However, we caution income-seeking investors not to get myopic when it comes to their CEF investments. For long-term investors, a CEF's total return is far more important than its distribution rate. This is true not only for CEFs but for all investments.

See locating total return data for more information.

Total return (share price) = share price return + distribution rate

  • Share price return = (share price end of period ÷ share price beginning of period) − 1

There are 2 ways to calculate distribution rates. The first way, which is the most relevant for shareholder returns, is at the share price

  • Distribution rate (at share price) = annualized distributions ÷ share price Share price = $15.00 Most recent monthly distribution = $0.10 Annualized distribution = 12 x $0.10 = $1.20 Distribution rate (share price) = $1.20 ÷ $15.00 = 0.08 = 8.0%

The second way to calculate distribution rate is at the net asset value. This is most relevant for determining the sustainability of the distribution.

  • Distribution rate (at NAV) = annualized distributions ÷ NAV NAV = $10.00 Most recent monthly distribution = $0.10 Annualized distribution = 12 x $0.10 = $1.20 Distribution rate (NAV) = $1.20 ÷ $10.00 = 0.12 = 12.0%

When a CEF announces an upcoming distribution, it generally announces 3 dates:

  • Record date: Shareholders of record as of the record date will receive the distribution.
  • Ex-distribution date: When buying or selling a CEF, as with a stock or an ETF, it takes 3 business days (in the US) for the trade to settle. That is to say, if you purchase a CEF on Monday, you won't officially be a shareholder of record until Thursday, assuming that the intervening days are business days. This is extremely important, because you must own a CEF before its ex-distribution date in order to receive the distribution.
  • Payable date: The date that the distribution is actually paid or reinvested.

All things being equal, a share price will reflect the amount of a distribution. For instance, if a CEF closed at $20.00 per share the day before its ex-distribution date, and its distribution was going to be $0.50, the morning of its ex-distribution date, it would open at $19.50. This doesn't always occur, but over time discrepancies tend to net out to $0.00.

Share price and distributions are linked together. Why does this matter? Some funds distribute more money than their portfolios are generating. They do this by distributing your own capital back to you. We call this destructive return of capital. Over time, a distribution consistently paid from destructive return of capital will erode a fund's NAV. With an eroded NAV, the fund has less capital to generate future income and capital gains. It is essentially distributing its capital as a distribution, instead of investing that capital to meet its investment strategy. Although a CEF's share price is largely independent of its NAV (because of discounts and premiums) in the short term, over a full market cycle the NAV typically prevails.

CEFs with unsustainable distribution policies, as history shows, will almost certainly be forced to cut their distribution amount in the future. If a fund's policy was to distribute 25% of NAV when the NAV is at $20 per share, the distribution amount will be $5.00 per share. A year later, when the fund has already paid out $5 of destructive return of capital, all else being equal, the NAV will be $15.00. Twenty-five percent of $15.00 is $3.75. This means the distribution amount will fall from $5.00 per share to $3.75, a 25% reduction. Shareholders are left with a declining NAV, more than likely a declining share price, a portfolio bereft of earnings power, and a highly reduced 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.