Understanding return of capital in closed-end funds

Closed-end funds that use equity or alternative asset investment strategies may help diversify and augment traditional income-oriented portfolios. Many of these funds use a managed distribution program to help facilitate smooth regular distributions to investors. The sources of these distributions include interest income, dividends, realized capital gains and potentially, return of capital — an important and often misunderstood component.

Nuveen’s managed distribution program seeks to convert the expected long-term total return potential of a fund’s investment portfolio into attractive, tax-efficient quarterly or monthly distributions. Like most managed distribution programs, fund distributions are based on an estimate of the portfolio’s future return. If the actual return falls short of the estimated return, the fund’s distribution may include a return of capital.

1. The fund’s capital: not just your original investment

A fund’s capital — its net asset value (NAV) — starts with shareholders’ initial investment in common shares. The value changes as the fund’s investment portfolio appreciates, depreciates, or generates and distributes income from dividends and interest. The components of the fund’s total return on NAV are its income and any gains, both realized and unrealized, after expenses.*

Regulations require a fund to distribute most of its investment income and realized gains each year.

If the fund distributes only its net investment income and realized gains, and has unrealized appreciation as well, the fund’s NAV — its capital — at the end of the year will be higher.

For most fixed income strategies, net investment income* makes up the majority of the fund’s total return, and the fund’s NAV is not typically affected much by unrealized appreciation over time.

2. Return of capital is a choice

What if the fund’s expected return consists mainly of appreciation, not income, as is true for many equity and alternative asset strategies?

The fund’s first choice: whether to pay a distribution amount that is greater than the required minimum of just net investment income and realized gains. To trade more competitively in the market, or to meet a stated goal of converting as much of the fund’s total return into regular cash flow as possible, the fund may wish to pay a higher regular distribution amount than regulations require.

If it has unrealized appreciation, the fund has a second choice: whether to realize some or all of its appreciation, selling portfolio securities to raise cash to increase its distribution amount. Selling appreciated securities creates at least two consequences: realized gains will be taxed in the current tax year at either long-term or short-term rates, the fund gives up future appreciation potential for the securities sold. 

To avoid either of those situations, instead a fund can pay the additional distribution amount from its capital. The fund’s capital consists of two sources:

1. shareholders’ initial investment, plus
2. the value of the unrealized appreciation, over its lifetime, if any.

For tax purposes, both sources are considered return of capital (“RoC”).

What happens when a distribution includes RoC?

If the RoC amount exceeds the fund’s unrealized appreciation, some or all of the RoC will represent part of the shareholders’ initial investment capital. If a fund continues to pay out part of this initial capital, its assets — and earning power — will diminish over time.

The fund still needs cash to pay the additional distribution amount. This cash can come from a variety of sources, including selling a depreciated security.

RoC typically is not taxed in the current year. Instead, it reduces a shareholder’s cost basis in the fund. When the shareholder sells his or her fund shares, any gains will consider the selling price relative to the reduced cost basis. This means that RoC usually defers some of the shareholder’s tax liability.

So, a fund’s choice to return capital can be an attractive tax-management decision, or it can diminish future earnings power, or sometimes both.

3. How to evaluate a fund’s RoC

When a fund returns capital, investors want to discern which situation exists: a good tax choice, diminished original invested principal, or some of both. The key is to compare a fund’s distribution rate on NAV with its total return on NAV over various time periods. Most managed distribution programs seek to match distributions to return over the long term, seeking to preserve shareholders’ original investments.

If a fund’s total return on NAV exceeds its distribution rate on NAV, any RoC is likely to be a decision that defers some tax liability into the future.