FINRA Investor Alert

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 issued an 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.