Saturday, November 2, 2013

FINRA Investor Alert: Closed-End Fund Distributions

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

The Financial Industry Regulatory Authority (FINRA) recently released an Investor Alert to draw investors attention to the subtle difference between distributions and returns in the context of closed-end funds.  Closed-end funds are pooled investments like mutual funds (which are also known as 'open-end funds'), but have only a fixed number of shares.  This distinction has a big impact on how the fund is analyzed.

Distributions from closed-end funds are typically quoted as a rate (e.g. 6%).  This 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" net asset value (NAV).  For example, if a closed-end fund with NAV of $10 per share paid $0.05 per share in the last monthly distribution, then the distribution rate would be $0.05*(12 months)/$10 = 6%.

What makes closed-end fund distribution rates different from the yields quoted for typical mutual funds is that closed-end fund distributions might also include a return of principal.  Returning principal to investors can, at least temporarily, inflate distribution rates and therefore give the false impression of strong performance.  This was the case for many non-traded real estate investment trusts (REITs), business development companies (BDCs) and master limited partnerships (MLPs). The way to combat this confusion is to look at the closed-end fund's total return.

The total return of a closed-end fund also includes the effect of changes in NAV and assumes that all distributions are reinvested into the fund.  Let's take an extreme example of a fund that generates no income and pays out all of their NAV in twelve monthly payments to investors.  The distribution rate for this fund will exceed 100% but the total return of the fund will be 0%!

FINRA offers six questions investors should ask themselves before investing in a closed-end fund:
  1. Does a closed-end fund fit into my investment objectives?
  2. What is the closed-end fund's investment strategy?
  3. How much of what I pay per share in an IPO will actually be invested?
  4. What are the tax implications?
  5. How is the distribution rate set?
  6. Are the shares trading at a premium or discount to NAV?
Closed-end fund investors would be in a much better place if they asked themselves these questions and were thoughtful about the consequences prior to investing in any closed-end fund.

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