Total return vs. distribution rate

Chasing after exceptionally high distribution rates can lead to disappointment—frequently those rates can be accompanied by a declining share price return.

  • Morningstar Morningstar
  • Closed-End Funds
  • Closed-End Funds
  • Closed-End Funds
  • Closed-End Funds
  • Closed-End Funds
  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print

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.

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.

Next steps to consider

It's easy—opening your new account takes just minutes.

Check to see which closed-end funds we offer.

Learn how closed end funds, mutual funds, and ETFs differ.

  • Facebook.
  • Twitter.
  • LinkedIn.
  • Google Plus
  • Print
close
Please enter a valid e-mail address
Please enter a valid e-mail address
Important legal information about the e-mail you will be sending. By using this service, you agree to input your real e-mail address and only send it to people you know. It is a violation of law in some jurisdictions to falsely identify yourself in an e-mail. All information you provide will be used by Fidelity solely for the purpose of sending the e-mail on your behalf.The subject line of the e-mail you send will be "Fidelity.com: "

Your e-mail has been sent.
close

Your e-mail has been sent.