Investors often flock to closed-end funds for income. The Invesco CEF Income Composite ETF (PCEF ) is an exchange traded fund that proves that point.
PCEF, tracks the S-Network Composite Closed-End Fund Index, sports a 30-day SEC yield of 7.12%, as of February 3. That’s staggering by today’s standards and alluring for income investors struggling with low yields on government bonds and broader equity benchmarks.
Still, investors considering closed-end funds or PCEF should be aware of the concept known as return on capital (ROC). As Alerian analyst Roxanna Islam points out, some investors think the worst of ROC and assume it’s a way for a closed-end fund to repay the initial investment, disguising it as a dividend. However, there’s more to the story.
“Most of the time, ROC is actually a tax concept rather than a literal return of principal, and in many cases, ROC is a good thing (e.g., can provide tax deferral benefits),” says Islam.
PCEF holds 124 closed-end funds that include exposure to taxable investment-grade and junk bonds and others that employ options writing strategies to boost income. Due to those methodologies and the holdings in taxable bonds, there are some ROC complexities that come along with owning individual closed-end funds.
“For closed-end funds, return of capital can be more complicated and can vary across asset classes. ROC can also offer some insight on the health of a fund’s distribution (with some caveats). In most cases, paying ROC distributions is an acceptable strategy for equity and alternative strategy funds to convert unrealized gains to distributions without having to sell holdings,” adds Islam.
As the Alerian analyst notes, the bulk of ROC associated with closed-end funds is considered “constructive.”
With closed-end funds, including PCEF components, the net asset value of the funds grows as underlying holdings appreciate in value. From there, dividends and realized capital gains are lobbed off to investors, but there are instances where not all of a closed-end fund’s gains are realized.
“Many fund managers like to forecast the fund’s annual gains and distribute it in fixed monthly or quarterly payments to investors (much like a fixed income payment),” concludes Islam. “Because unrealized gains are considered part of the fund’s NAV, distributions paid from these gains are considered ‘return of capital’ even if the NAV is well above its initial value. This type of ROC is typically viewed positively because it provides stable distributions without unnecessary selling of holdings.”
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