By Brendan Conway
A “distribution” isn’t the same thing as a “yield.” Watch out for closed-end funds returning your own cash as a distribution. Handing back investor assets to fill a short-term need simply makes it harder to generate long-term returns, since there’s less money in the fund with which to do it.
That’s the gist of the warning this week from the Financial Industry Regulatory Authority in “Closed-End Fund Distributions: Where is the Money Coming From?”:
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. …
How is the distribution rate set? A fund’s prospectus or distribution announcements should provide you with an understanding of the sources used to make distribution payments or if the closed-end fund follows a managed distribution policy. If you see frequent returns of capital, ask why the fund is not generating enough income to fund distributions. Also, keep in mind that a fund’s current distribution rate is not indicative of the future distribution rates you can expect.