Avoid committing this dividend investment blunder in 2025:
What people adore about closed-end funds (CEFs) mainly boils down to their allure: the dividends! These income-focused investments dish out typical yields of 8.7%, which can significantly contribute to ensuring a financially secure retirement.
Besides dividends, CEFs offer numerous other reasons to be included in your investment portfolio. One such advantage is the opportunity to invest in a diverse range of high-quality assets. CEFs, being well-regulated, contain a variety of assets such as stocks, bonds, and real estate investment trusts (REITs).
However, the question arises as to whether CEFs' high dividend yields can be sustained over a prolonged period, given that S&P 500 index funds yield less than 1.3%. Yet, CEFs manage to yield more than six times as much by investing in similar assets.
Here are three possible explanations:
- Some CEFs do indeed pay excessive dividends, making the selection of the right CEFs crucial.
- The S&P 500 has recorded a total return higher than 8.7% in the past decade, making it possible for CEFs to cover their dividends using the returns from the market.
- Since CEFs generally trade at a 5.8% discount to net asset value (NAV), the high dividend yield (based on the market price) translates to a more manageable 8.2% when calculated based on NAV. This scenario is more favorable, especially for severely discounted funds.
So how do you separate the genuine CEFs from the impostors?
#1 Dividend Investing Blunder
One common misconception that often attracts novice CEF investors is the concept of "return of capital," or ROC. At first glance, it seems that these fund managers are essentially returning your money with a charge for their services.
This misconception overlooks the reality that ROC can be advantageous for investors in many instances. David Schachter, VP of several Gabelli CEFs and the ombudsman for the Gabelli Utility Trust (GUT) and GAMCO Natural Resources, Gold & Income Trust (GNT), had this to say: "The negative connotation surrounding ROC is often uncalled for."
The reason behind its positive impact is that, unlike in certain situations, ROC in CEFs is usually not simply the return of capital minus fees. Instead, it serves as a strategic tool for fund managers to lower investors' tax burden.
In fact, Schachter substantiates this assertion by pointing out how GNT passed on profits and passive income to shareholders with a lower tax burden through ROC: "Last year, in 2023, GNT recorded a positive return of 9.8% in NAV. The distribution was 87% in the form of tax-free ROC." As a result, GNT shareholders benefited from reduced tax burdens.
Now, you might be wondering: What distinguishes "good" ROC from "bad" ROC?
"Bad" ROC transpires when you receive your capital back with fees deducted.
"Good" ROC is a bit more complex, as it depends on the fund's specific situation. Let's examine an example to better understand this distinction.
Suppose this hypothetical CEF holds shares in two companies, ABC and XYZ, as well as stocks in DEF and GHI. The fund boasts substantial profits from ABC, smaller profits from DEF, and losses from XYZ and GHI.
Despite the losses, the fund's management is optimistic about GHI's short-term profit potential and XYZ's long-term profit potential, while DEF is expected to continue its growth, albeit at a slower pace than ABC, due to its recent substantial gains.
Assuming the fund needs to distribute $2 million to shareholders as dividends, the prudent approach would be to sell off shares in ABC to cash in on the profits. However, selling ABC shares constitutes a taxable event. Thus, the fund implements the following strategy:
- Sell 100,000 shares of its one-million-share position in ABC, raising $8 million in cash (including $3 million in profits) to pay the $2-million dividend.
- Meanwhile, the fund sells 200,000 shares of XYZ to raise $5 million (realizing the $3-million loss from XYZ) and reallocates $2 million of cash to DEF and GHI.
The result is that the fund incurs no capital gains whatsoever. As a consequence, it is able to distribute $2 million to shareholders, with the IRS viewing this distribution as a return of capital.
Additionally, the fund now has $9 million in cash. Once the wash-sale rule expires 30 days after this transaction, the fund can reinvest the $9 million in XYZ or any other stock, thus maximizing shareholder benefit and minimizing tax costs.
This is a prime example of how managers balance winners, losers, and the tax code to optimize shareholder gains and minimize tax expenses. This can be particularly beneficial if you're investing in an account that is not tax-advantaged, especially if you're in a higher tax bracket.
Michael Foster serves as the Lead Research Analyst for Contrarian Outlook. For more lucrative income ideas, click here to access our latest report, "Indestructible Income: 5 Affordable Funds Delivering Steady 8.6% Dividends."*
Disclosure: none
- Investors should be aware that not all CEFs that distribute high dividends are genuine, and selecting the right ones is crucial to avoid excess fees when receiving return of capital (ROC).
- Schachter, a VP of Gabelli CEFs and the ombudsman for certain funds, argues that ROC can lower investors' tax burden by allowing fund managers to distribute profits and passive income in a tax-efficient manner.
- According to Schachter, funds can minimize tax expenses by selling winning stocks, realizing losses on losing stocks, and then reinvesting the remaining cash in new investments when the wash-sale rule expires, which can maximize shareholder benefits in non-tax-advantaged accounts.