Sick Dividends

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By the Sick Economist


You really can visualize a Closed End Fund as a financial vehicle. That is because a CEF itself is a kind of entity that carries other securities inside of it. For example, the Tekla World Healthcare Fund (Ticker: THW) is a closed-end fund that carries within it shares of major publicly traded healthcare companies. Also within the fund is a certain amount of borrowed money. This means that the fund yields 8.2% monthly; if you had bought the healthcare shares outright, they might only yield 3% quarterly. In this example, the CEF is the vehicle and the securities and leverage inside are the passengers.

You can think of the CEF world as a highway. At any moment when you are driving down a crowded highway, you might see hundreds of different kinds of vehicles; some large like a bus, others small like a Fiat. Each vehicle might have different passengers. But they all have a few key things in common; they all have wheels, they all have a steering wheel, and they are all trying to get somewhere. Same thing with closed-end funds.

On the highway to income, you might see Tekla World Healthcare, which borrows a lot of money and specializes in brand name healthcare stocks. But you might also see a fund that invests in municipal bonds, a different one that carries utility stocks, and finally a third one loaded with preferred shares. Each one may carry different quantities of borrowed money, and each one may have a management (or driver) who drives more or less aggressively. But almost everything on this highway pays better dividends than regular stocks.

Why are these vehicles called closed-end funds? What does that even mean? Well, an open-end fund is a typical mutual fund or exchange traded fund, where the fund’s managers can create just as many shares as the market demands. So the share price of the mutual fund or exchange traded fund typically very closely tracks the value of the underlying assets (also known as NAV, net asset value). In a closed end fund, the entity only has so many fixed shares. So the shares themselves trade based on supply and demand, and may exceed the NAV in value, or lag the NAV. This can create mismatches that can be exploited by astute investors. It’s not uncommon for a closed end fund to trade below the value of the fund’s assets. So, a closed end fund consisting of utility stocks could trade at $10 per share on the open market, but the NAV is currently $11. In this case, you can buy shares in the fund for less than the current value of the underlying assets. As you might guess, this is called buying at a discount. You could literally get a $1 worth of value for $0.90!

Typically, open-ended mutual funds and exchange traded funds don’t employ leverage. So, whatever yield the underlying securities produce is what you get. For example, the Select Spider Healthcare ETF (Ticker: XLV), one of the most widely held open-ended healthcare funds, currently yields about 1.6%. The Tekla World Healthcare fund pays around 8% every month! Leverage is the magic fuel that has turbo charged the Tekla vehicle. That sucker is now flying down the highway.

Some Words About Leverage

If leverage can boost your dividends from 1.6% to 8%, it must be the greatest thing ever, right? Does that mean that everyone should be borrowing?

No. There are a few times when I might recommend that regular investors borrow at today’s crazy low interest rates, but generally it’s too risky for most people.

Investing borrowed money is the only way that you can actually lose more than you own. If you have $100 to invest, and you make a poorly advised bet, you can lose all of the $100 (although this is very rare). Then you have $0. That outcome hurts, but may not be the end of the world.

If you have $100 to invest, and you borrow another $100 to invest, then you can potentially lose $200. At the end of this bad bet, you are actually $100 in the hole! Investing with borrowed money is often a “live by the sword, die by the sword” proposition, and typically not suitable for your standard retiree.

When you choose to invest in a closed-end fund, there are a few protections that moderate your risk. First and foremost is the law. CEFs can only take on a certain amount of debt as per the law. According to the Investment Company Act of 1940, the maximum amount of debt that a CEF can carry is $1 for every $3 in assets (33.3% of assets). To put things in vehicle terms, this means that each car on the highway must have, at a minimum, a seat belt, good breaks, and a reasonable speed limit.

Another reason why leverage is best left to a CEF is because the sponsors of these companies have deep Wall Street connections and can borrow money on very good terms. At this point, many of the larger CEFs are literally borrowing money at interest rates of less than 1%, with very flexible repayments terms. It’s highly unlikely that you, as an individual amateur investor, could borrow money on these fabulous terms.

Lastly, most CEF managers have decades of experience in very specific niches. The fact that the industry is regulated by a law that was promulgated in 1940 demonstrates that these managers potentially bring a lot of experience to the table. They are not necessarily any smarter than you, but they are more experienced. They may know when to hit the gas and when to hit the breaks in terms of leverage, and they may utilize sophisticated derivative strategies (calls and puts) to protect against sudden movements in interest rates. Oftentimes, they also have very deep expertise in the particular securities that their fund invests in. For example, the Double Line Income Solutions Fund (Ticker: DSL) boasts a team of managers that specializes in mortgage bonds and foreign sovereign bonds. They don’t do pharma stocks or utility stocks; they just offer dozens of years worth of experience in certain kinds of bonds. Can you say the same for yourself?

Red Light, Yellow Light, Green Light

As you are cruising down the CEF highway, there are some key factors that need to be considered as you select the right funds for you.
The first thing that you need to check when a fund grabs your eye is if the fund can cover it’s monthly dividend distributions through organic earnings. If a fund meets it’s monthly obligations through return of capital, that is a yellow or a red light.

You may have heard the term, “Return of Capital” in discussions concerning REITS. While in the REIT world, return of capital can be a good thing, in the CEF world, the same term means something very different. Closed-end funds are famous for steady, generous monthly distributions. But it’s important for you to understand just a little bit about the engine that makes your vehicle function.

Most CEFs follow what is referred to as a managed dividend policy. This means that every fiscal year, the board of directors decides on a fixed amount of dividend and pays that amount out every month. The idea is to provide certainty and regularity to retirees like yourself who live off those dividends.

There are four ways that a CEF can generate those payments every month. The first way is through net investment income. This means that, in any given month, the securities inside the fund threw off enough cash to meet the monthly distribution goal. Because up to 33% of the securities were purchased with debt, they should throw off more income than a normal portfolio with no leverage would throw off. Strong, consistent net investment income is a big green light for you.

The second way that a fund could generate cash for monthly distribution would be through net realized short-term capital gains. This would mean that the share price of the passenger securities within your vehicle have appreciated lately. So management choses to sell some of those shares, reaping the capital gains, and funnel some of the profits your way. This is a good enough way to generate income for investors, but it’s the reason why CEFs don’t appreciate over time the way a plain exchange traded fund would. Most of the benefit you will receive as a shareholder in a CEF will come from your monthly income; that is because some or all of the capital gains are liquidated on a regular basis and paid out to you.

The third way that a fund could generate that monthly cash payout would be net realized long-term capital gains. This is exactly the same concept as method number two, except it’s selling some passenger securities that have been inside the fund for a long time. The only difference between method #2 and method #3 is taxation. Long-term capital gains are taxed at a lower rate than short-term, so that makes method #3 somewhat preferable.

Your yellow light or red light occurs when you see “return of capital.” In this context, this means that your fund did not generate enough money this month to make the payout, so the fund is just taking a portion of your own invested capital and handing it right back to you. This can be a useful and beneficial tool to some fund managers in some cases, but it’s often widely abused.

Return of capital is a beneficial tool in some cases because it allows management to maintain the managed distribution policy without disturbing the regularity of your income. So, for example, if a certain fund pays you $100 every month, for years on end, and one month the fund doesn’t generate that much cash organically, the fund managers might employ the return of capital. That way, your monthly income is not interrupted, and your lifestyle is not disturbed. They might send you $50 from profits, and $50 from return of capital. Or $90 from profits and $10 from return of capital. Or, on some really bad months, 90% return of capital.

In the world of REITs, return of capital is merely an accounting term with little relation to reality. In the CEF world, return of capital has real consequences. Whatever amount is sent to you that is not profit, (i.e. return of capital) gets deducted from your fund’s net asset value (NAV). In other words, in the CEF world, return of capital literally means return of capital, so the value of the assets of your fund is reduced. If we go back to our vehicle analogy, when a CEF returns your capital, they are throwing things out the window. First they throw out a passenger’s sunglasses. Then they throw out a passenger’s iPhone. If management isn’t careful, they wind up throwing whole passengers out of the vehicle. You left your destination with ten passengers loaded with belongings and arrived at your destination with just seven passengers stripped of their sundry possessions. Not good. Not good at all

Unfortunately, the apparent complexity of this situation scares away too many investors from what is really a superior asset class. If this all sounds too complicated for you, stay calm! I am about to make it very easy.

It’s very easy to check on the health of any closed-end fund. Simply look for a document entitled 19(a). “19a” stands for Section 19(a) of the 1940 Investment Company Act. That’s right, CEFs have been compelled to follow more or less the same rules of the road for more than 80 years. If millions of Americans have figured these rules out over several generations, you can, too.

You can typically find these 19(a) forms on the website of any closed-end fund. The 19(a) form is a simple form that the fund must file, every month, that explains the source of it’s distributions for that month. For example, if you go to the website for the Cohen & Steers Infrastructure Fund (ticker: UTF), you can easily find monthly 19(a) forms going back for years.

This form is a very basic grid that will show you, each month, where your payment came from. If your payment was 90% net investment income and 10% return of capital, the form will show that clearly. And vice versa.

The Cohen & Steers Infrastructure Fund is an example of a CEF that has used return of capital responsibly. After clicking on a few of the 19(a) forms from 2020 and 2019, it’s plain to see that most months, their payment comes from net investment income and long-term capital gains. Occasionally, when they have a bad month, they use return of capital to fill in that gap. That way, I can count on my steady payments no matter what. That small amount is deducted from the underlying net asset value. But in good months, they replace what they took out, and in fact, over the last decade, the fund’s net asset value grew by about 10% a year, despite the occasional returns of capital. This is a status green light.

Other funds are not as responsible. They over promise on their monthly distributions in a bid to attract as many investors as possible. They know they can abuse return of capital, slowly depleting the NAV, because they are counting on an investor base that is not educated, does not ask questions, and does not supervise management. As long as you check those19(a) forms a couple times of year, that group of chumps will not include you.

When it comes to superior monthly income, too many investors are puttering along on vespas or used Hondas, settling for 2 or 3% annual distributions, when they could be cruising in Porsche like CEF’s that yield 8 or 9% annually. Of course, driving a vespa is easier; it goes slower and rarely wrecks. If you want those better distributions, upgrade your driving skills and knowledge, and upgrade your investment vehicle.

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