Written by Nick Ackerman, co-produced by Stanford Chemist
Closed-end funds easily yield more than other investments out there. They pay out more than most ETFs, open-ended counterparts and generally more than individual companies. This is because they can pay out distributions from sources other than just the net investment income that they take in. Thus, the meaning behind why we typically call them distributions. This more accurately reflects that the payout is coming from additional sources. Whereas the term “dividend” would typically refer to income taken in by a company and paid out to shareholders. Either way, it is an entity that is paying shareholders a portion of their cut in the business. Being more technical and specific, one would call them distributions.
CEFs can be a great investment to generate income for investors in retirement. They produce outsized yields compared to other security types. The average distribution rate for a CEF as of 10/31/2020 is 7.72%. This includes all CEFs, fixed-income, equity and everything in between. They can do this for a few reasons. This includes the sources being distributed out that include; net investment income, short or long-term capital gains and even return of capital in some cases. These are all distributed out throughout the year in, generally, equal payments. This is dependent on the fund’s managed distribution policy if they have one or not.
This is why they can make regular monthly or quarterly distributions. Even when the earnings from the fund aren’t as regular. As we know, the market can be quite volatile and is constantly changing.
More Exotic Strategies
Besides just the sources of distribution is in how these instruments can generate returns. These can include more exotic strategies. Whether a fund is using leverage, options or private investments – it can lead to potentially greater returns and a way for funds to pay out more to investors.
The most common way to attempt to enhance returns is through utilizing leverage. This can be done either by borrowing debt or issuing preferred shares. A couple of examples of this are Reaves Utility Income (UTG) and Gabelli Equity Trust Inc. (GAB.PK). UTG has total net assets of $1.678 billion, as of their latest Semi-Annual Report. However, they also have borrowings of $445 million, making total managed assets at that time $2.123 billion. GAB has total common assets of $1.5 billion, but issues preferred shares of approximately $400 million in value. These preferred issues are actually traded on an exchange just like the common shares. A couple of examples currently that they offer are Gabelli Equity Trust Inc, 5.00% Series H Cumulative Preferred Share (GAB.PH) and 5.875% Series D cumulative Preferred Shares (GAB.PD).
These borrowings or issues are then used by the management to potentially enhance returns and income. The hope is to see a return above and beyond the cost of the leverage. However, this does add additional risk to the funds. This is because during recessions these instruments tend to be a drag on performance because they can not outearn what they are costing the fund. Additionally, NAV would be dropping faster due to the added investments that debt provided the fund.
Funds also operate with an options strategy that can further potentially enhance “income” generation. Lately, this is through collecting premiums for shareholders, which are classified as capital gains – not technically income.
These are typically carried out by writing calls. Writing calls on the underlying holdings of the fund can help generate options premium. This premium is then collected by the fund and paid out to shareholders. The option premium is generally accounted for as ROC to an investor. In the right funds, this ROC is merely for tax accounting rules and not “destructive” ROC. Destructive ROC would occur when the fund pays out too much to shareholders. The fund then ends up eroding the NAV of the fund by paying out more than what the fund can sustain. Some funds write calls on indexes such as the S&P 500 or NASDAQ. Some of the more popular funds in this category are from Eaton Vance (EV). These include Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV) and Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (ETW).
Return Of Capital
This is continually a hot topic in the CEF space and deserves its own brief explanation. We have explored this topic further in the past. It is well-deserving of its own section in this piece as it can often be a confusing source for distributions. It will undoubtedly be brought up.
Several of these EV funds will show ROC in their distribution, while at the same time their NAV can stay level or only show minor declines. This happens because they are taking losses on one side of the trade or the other. They can generate losses on their options strategy that is offset by the appreciation in their portfolio. Additionally, they can generate realized losses on their underlying portfolio – but helped be offset by gains in their options strategy. Thus, they can generate realized losses one way or another that is offset, either in whole or part, by unrealized gains elsewhere.
Utilizing ROC in distribution shouldn’t necessarily be viewed as automatically negative. There are reasons that ROC can show up in distribution. Again, ROC is a tax term and not a term for the performance of the fund.
MLP funds will additionally show ROC in their distributions. Remember, a CEF is only a wrapper and not a business in itself. Thus, the distributions are passed through to shareholders. Shareholders receive the same tax classification that the underlying portfolio is generating. MLPs typically pay out ROC due to all the depreciation they can write off.
This is also a factor in REITs, though this isn’t as common as we see in MLP funds or EV’s index option writing funds.
Sustainability – Is It Safe?
With all of this being said, how do you know distribution or dividend is safe?
Unfortunately, there is no way of knowing for sure. One can track historically what most fund sponsors have done with their fund, but ultimately, a fund can pay out whatever they want. This can also be for as long as they want. In general, we know that Eaton Vance typically is more conservative in its distribution. BlackRock as well, they don’t seem as though they are the first to start cutting – but they don’t let their funds run too high either.
It is when you get in a bit more of the exotic funds, with unique strategies and managed plans that might just simply make less sense. That is on the surface they might not appear to make sense anyway.
For example, the Cornerstone funds; Cornerstone Strategic Value Fund (CLM) and Cornerstone Total Return Fund (CRF). The fund sponsor knows their 21% distribution isn’t sustainable – yet they continue to pay it out to investors. It has been met with the inevitable decline year over year. However, that doesn’t mean the end result can’t be attractive, with positive returns. In fact, the funds are overweight tech – so they have done quite well on a YTD basis for 2020. This seems to be in an attempt to run up the premium on the fund to offer additional shares. These additional shares at a large premium will be accretive to the fund, so that is positive. The large distribution essentially keeps the cycle going; though they have been unable to get an appropriate premium for a couple of years now.
Taking a page from this book seems to be the RiverNorth offerings. However, their managed distributions don’t seem to be quite as high. RiverNorth Opportunities Fund, Inc (RIV) targets a distribution of 12.5% on the NAV annually. This is the same target for their fund RiverNorth/DoubeLine Strategic Opportunity Fund, Inc. (OPP). They then conduct frequent rights offerings. The last ones haven’t seemed to be so successful as discounts increased on the fund.
The bottom line, a fund can pay what they want, and when they want to.
Today’s piece was an attempt to explain why CEFs can offer higher distributions. This was to help introduce newer investors or new investors to the CEF space to the topic.
The bottom line is that it can contain sources other than just income like many other investments pay. This essentially means they are paying out all of their “earnings.” This is exactly why many CEFs don’t show share price appreciation over time. There are those that do, of course, like anything there are exceptions. However, that isn’t necessarily a bad thing either as this is exactly what retired or income investors need – most of their cash coming out to them monthly or quarterly. This allows them to either live their life, spending the cash on expenses.
It could also simply be a bit easier psychologically for investors to receive regular dividends. Even if the market is crashing and burning, one is still getting distributions from CEFs. It is a rare occurrence when a CEF suspends a distribution. This does happen on occasion though. The most recent example being some of the Tortoise funds that suspended them in 2020 but have since reinstated their distributions. That is the outlier though with a sector-specific risk in the energy sector and not the usual.
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Disclosure: I am/we are long UTG. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article was originally published to members of the CEF/ETF Income Laboratory on October 31st, 2020.