CEF Distributions

Except for a handful of exceptions, CEFs themselves do not pay taxes.

Instead, like open-end mutual funds and ETFs, CEFs pass the tax consequences of their investments onto their shareholders.

To maintain tax-free status, a CEF must pass onto shareholders, generally speaking, roughly:

• 90% or more of net investment income from dividends and interest payments
• 98% or more of net realized capital gains

Investors should be aware of the source of their distributions.

CEF distributions have four potential sources:

1. Interest payments on fixed-income portfolio holdings

2. Dividends from equity holdings

3. Realized capital gains

4. Return of capital:

• Pass-through (from master limited partnership investments, primarily)
• Constructive (from unrealized capital gains)
• Destructive (investors are literally receiving their own capital, minus expenses)

For accounting and tax purposes, distributions must be linked back to the initial source: usually dividends, income, and/or realized capital gains. These are actual cash inflows into the fund.

When the distribution exceeds the cash generated from these sources, the fund must ascribe the initial source as a return of capital.

Throughout the calendar year, funds estimate the breakdown of their distributions. Shareholders receive a Form 1099-DIV in January with the actual distribution breakdown for the prior year for tax purposes. Any previous information regarding the categorization of distributions are only estimates.

Prospective investors are at a disadvantage because they do not have access to the tax forms. They must wait until the fund files its annual statement to see the finalized distribution breakdowns in order to discern its use (if any) of return of capital.

Morningstar.com displays a fund's most recent distributions, along with their sources, as well as distributions for the four previous calendar years.

I chose ETV as an example screen shot from Morningstar as it shows all the types of distributions being used.  Return on Capital is a red flag for me as it can be very destructive to the fund if you do not know which type of ROC is being used (Pass thru, Constructive or Destructive)  I tend to make a worse case assumption when I see ROC is being used.  In this case I looked at the NAV history over 2 years and it appears ETV is not using the destructive exclusively but I think in some months it is being used.  The NAV in January 2014 was $14.53 and in July 2014 the NAV exceeded $15.  But in January 2016 NAV was $13.39.  I would not be interested in this CEF for a couple of reasons.  One is I don’t trust the ROC distributions and the other reason is that it is selling for $14.84 with a NAV of $14.02.  This is a 5% premium which in effect has you paying $1.05 for $1.00 of asset.

The takeaway from this is that when looking at CEF’s it is important to look at the distribution  and understand how it is being paid.  It is one of the several things that need to be evaluated in a different light then regular stocks are looked at.