Closed-End Fund Distributions: Where is the Money Coming From?

You may have considered investing in a closed-end fund as a way to generate income when other investments did not seem to offer what you may have been looking for. Closed-end funds have become popular products because some offer high distribution rates—as high as 6 percent or more. But be aware that a fund's distribution rate is not the same thing as its return—even if the numbers might look similar. And before you invest, be sure you understand where the closed-end fund is getting the money to pay distributions. In some cases, part of the distribution comes from the return of principal.

 

FINRA is issuing this alert to explain what closed-end funds are, how they differ from traditional mutual funds, what a distribution rate is and what to ask before investing.

 

Closed-End Funds Basics

 

A closed-end fund is a type of investment company that pools money from investors to buy securities. Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments (including illiquid securities). Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange.

 

When you buy shares in a closed-end fund IPO, you'll pay a premium because the fees and expenses paid for the offering come from the capital raised. In other words, if you pay $10 for a share, the actual amount invested for you will be less than $10. After a closed-end fund goes public, you can buy shares in the secondary market on an exchange, such as the NYSE or NASDAQ, paying the fees that your broker charges for this type of transaction.

 

Because closed-end funds trade like stocks, the supply and demand for the shares determines their market price. Both closed-end funds and mutual funds have an inherent net asset value (NAV) that reflects the value of the funds' underlying assets (less liabilities) divided by the number of shares outstanding. Closed-end funds also have a market price that fluctuates throughout the trading day, and that price may be higher or lower than its NAV. You may get information on a closed-end fund's current price and NAV on the fund's website or that of the exchange where it trades. Information on a fund's portfolio holdings is usually available on the fund's website and company filings submitted to the Securities and Exchange Commission.

 

Closed-end funds have historically traded at a discount to NAV—that is, at a market price lower than the fund's NAV. Some closed-end funds, however, may trade at a premium to NAV—that is, at a market price higher than the fund's NAV. One reason may be that investors looking for a high distribution rate may be willing to pay that higher market price to get the distributions. In contrast, shares of a mutual fund are always priced based on the NAV, which is set daily at the close of trading.

 

Closed-end funds and mutual funds share some other features. For instance, both closed-end funds and mutual funds charge investors annual fees and expenses. Both fund types might use leverage to enhance their returns, which can magnify a fund's gains as well as its losses. But while closed-end funds and mutual funds can invest in illiquid securities, closed-end funds are not impacted by redemptions as mutual funds are and they are allowed to hold a greater percentage of illiquid securities in their investment portfolios.

 

Distribution Rates: Understand Where the Money Comes From

 

Closed-end funds typically pay distributions to investors on a monthly or quarterly basis, and may increase or decrease the distribution rate from one distribution period to the next. Depending on a closed-end fund's underlying holdings, its distributions can include interest income, dividends, capital gains or a combination of these types of payments. In some cases, distributions also include a return of principal, sometimes referred to as a return of capital. That means the monies used to pay the distribution come from the fund's assets rather than from any income generated by the investments in the fund's portfolio.

 

Closed-end funds that return capital can carry a higher level of risk because the fund is eroding the asset base it has to generate income to pay distributions. Some closed-end funds set a specific distribution rate to pay regardless of the income generated by the fund. In that case, it is more likely that a fund may return capital to investors along the way. Before you invest in a fund, find out if the closed-end fund follows this approach—also known as a managed distribution policy.

 

Distribution Rate, Total Return or Yield: What is the Difference?

Take care not to confuse a closed-end fund's distribution rate with the fund's total return. In general, a distribution rate is calculated by annualizing the most recent amount paid to investors and dividing the resulting amount by either the market price or the fund's NAV. The total return from a closed-end fund will take into account the change in share price from a specific point in time and the income the fund paid. Total return figures for closed-end funds usually assume all distributions were reinvested in the fund.

When looking at closed-end funds and traditional mutual funds, keep in mind that distribution rates and yields are different measures. A mutual fund's yield shows its interest and dividend income expressed as a percentage of the fund's current share price. With a closed-end fund, the distribution rate might also include a return of principal.

 

You can get information about a closed-end fund's distribution rate from the fund's website, its annual report and company announcements. Every time a fund pays a distribution, it must also provide a written statement about the sources it is tapping to pay the distribution. In addition, closed-end funds notify investors of the sources once a year in IRS Form 1099-DIV. You need to pay attention to the sources and amounts reported because a return of capital has different tax consequences than a distribution of interest income, dividends or capital gains.

 

Six Questions to Ask Before Investing in a Closed-End Fund

 

  1. Does a closed-end fund fit into my investment objectives? If unclear, you may want to consult with someone who understands your investment objectives, time horizon and risk tolerance to see how closed-end funds fit with your investment objectives. An investment professional should understand these complex products and be able to explain how they may fit with those objectives.

     

  2. What is the closed-end fund's investment strategy? The fund's prospectus or most recent annual or quarterly reports will have details about the fund's investment strategies, risks, proposed sources of distributions, intended use of leverage and management costs. If the fund invests in bonds, look at how its net asset value has fluctuated as interest rates have changed over time. Be clear on whether the fund's strategy involves volatile or illiquid investments that may carry more risk. You should also understand the fund's distribution policy. Remember that past performance does not indicate or guarantee future performance. You can obtain the prospectus and other company reports on the SEC's EDGAR database, the fund's website or through your broker.

     

  3. How much of what I pay per share in an IPO will actually be invested? Typically, the IPO price may include a "built-in" sales charge of up to 5 percent of the price that goes to the broker who sells you the shares, plus a separate amount for the offering expenses. Read the fund's prospectus and talk to your broker to understand how much of the price you pay will actually be invested to work for you.

     

  4. What are the tax implications? Like mutual funds, closed-end funds do not directly pay taxes but instead "pass through" tax obligations to investors. So you need to understand how any closed-end fund distributions you receive will impact the taxes you owe. Remember that you have no control over the timing of the distributions you might receive, the sources that the closed-end fund will tap to pay them or the tax treatment that will apply.

     

  5. How is the distribution rate set? A fund's prospectus or distribution announcements should provide you with an understanding of the sources used to make distribution payments or if the closed-end fund follows a managed distribution policy. If you see frequent returns of capital, ask why the fund is not generating enough income to fund distributions. Also, keep in mind that a fund's current distribution rate is not indicative of the future distribution rates you can expect.

     

    TIP: Closed-end funds aren't the only investment that offers distribution rates to attract investors. When considering an investment in non-traded real estate investment trusts (REITs), business development companies (BDCs) or master limited partnerships (MLPs), you should ask the same question about distributions.

     

  6. Are the shares trading at a premium or discount to NAV? While you may not be able to determine why a closed-end fund's shares are trading at a premium or discount to NAV, be sure to find out—from the closed-end fund's website or exchange where it is listed—how the price you are paying compares to the fund's inherent value. This fact is important to know because it will affect your total return. In either case, be sure to find out whether the fund's distributions include a return of principal. If so, consider whether you want to make an investment just to get your money back.

 

Additional Resources

 

 

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Last Updated: 10/28/2013