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Money Management: The value of return of capital in closed-end funds

Byron S. Sass

Byron S. Sass

Closed-end funds are similar to their mutual fund cousins but contain some key differences. One of the key differences is how shares are issued and traded. While mutual funds can issue an unlimited amount of shares and are redeemable at net asset value at the end of the day, closed-end funds issue shares once and then trade like an equity on an exchange based on supply and demand.

This allows closed-end funds to have a static pool of assets. It also lets the fund manager take advantage of investment opportunities without having to worry about raising money for share redemptions, as is the case with mutual funds.

As a result, some closed-end funds purchase less liquid securities. For assuming some liquidity risk, the funds are compensated by receiving a higher yield. This is one reason closed-end funds are viewed favorably by investors. Because they tend to contain higher yielding securities, they can also offer attractive dividends.

However, not all closed-end funds earn the entire distribution from their investment operations. When this occurs, they can cut their dividend or continue to pay the full dividend with a mechanism called return of capital. Depending on whether the fund is trading at a discount or premium, this can be a positive or negative for investors.

Defined, return of capital within a closed-end fund is when a fund returns principal to the shareholder. This can occur when a fund has a required distribution target but they do not earn the entire distribution amount from their investment activities. For example, if a share of XYZ fund has a net asset value of $10, and has a required distribution of 10 percent, they would have a dividend of $1. If XYZ fund only earns $0.25 per share throughout the year, because of their required distribution policy they are still required to pay out the remaining $0.75 of income throughout the year.

Where, then, does the other $0.75 come from? It comes directly out of the net asset value of $10. In our example, the new net asset value of the fund would be reduced to $9.25 (or $10 plus the $0.25 it earned minus the $1 for distribution). Given our example, one may wonder why an investor could view a return of capital as a positive. To answer this question, we must first look at whether the investor the fund is trading at a price above or below the value of the fund’s underlying assets.

To explain further, it is helpful to understand that closed-end funds have a unique feature in that at the end of every trading day the net asset value of the fund is published and we can compare the next morning if the shares of the fund traded above or below total value of the securities within the fund.

When a closed-end fund trades above the value of its underlying net assets (computed on a per share basis) it is said to be trading at a premium. Conversely, when it trades below the value of the fund’s net assets it is called a discount. These premiums and discounts can be substantially large and occur in large part due to supply and demand or because the asset class of underlying investments comes in our out of favor with investors.

Continuing with our return of capital example and rudimentary knowledge of closed-end fund discounts/premiums, if we further assume that XYZ fund was purchased at discount of 10 percent and the same 10 percent distribution discussed above, we can understand how value is added through the return of capital. As stated above, XYZ fund’s return of capital was $0.75. However, because we purchased the fund at a 10 percent discount, we actually only paid $0.675 in return for $0.75. Therefore, by purchasing the hypothetical fund with a required 10 percent distribution at a discount, we received $0.075 of income per share for free.

As the discount on the hypothetical fund continues to narrow, the added value of the return of capital begins to have a smaller effect. Indeed, once the fund trades at par or even at a premium, a return of capital has the inverse effect and becomes harmful to investors. Though the value of return of capital can be debated by analysts, from the view of an investor who purchases a closed-end fund at a discount, an investor will gladly pay less to receive more without taking on additional risk. To learn more about whether closed-end funds may help you reach your financial goals, contact your financial professional for more information.

Byron S. Sass is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

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