The Potential Misguidance of Capital Repayment for Closed-End Fund Shareholders
Yesterday, we delved into the nuances of return of capital (ROC) being both beneficial and detrimental for investors in high-yielding closed-end funds (CEFs) with rates above 8%. Contrary to popular belief, ROC actually serves as an advantage when it comes to top-tier CEFs.
In this article, we will examine real-life instances to establish how ROC constitutes a significant portion of a fund's total returns. By examining five Nuveen funds, such as the Nuveen S&P 500 Buy-Write Income Fund (BXMX), Nuveen Dow 30 Dynamic Overwrite Fund (DIAX), Nuveen S&P 500 Dynamic Overwrite Fund (SPXX), Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX), and the Nuveen Core Equity Alpha Fund (JCE), we will analyze how they effectively use ROC to produce income for investors.
Apart from JCE, these funds employ an index-based strategy where they purchase the index's corresponding shares and sell call options on a portion of it, which ultimately converts volatility into income for investors. These funds have a solid track record in implementing this strategy, with four out of five - BXMX, SPXX, and QQQX - surpassing the 100% mark in the last decade. DIAX is the only exception, with a 86.4% gain primarily due to its slower index growth compared to BXMX, SPXX, and QQQX.
Covered-call funds can benefit a well-diversified portfolio by offering above-average income yields, as they currently produce an average yield of 7.2%. This is significantly higher compared to the 1.3% yield of the average S&P 500 stock.
Explaining Return of Capital
Despite offering sizeable income, return of capital (ROC) often incurs criticism as investors dismiss these funds as simply charging fees and returning the capital. As evident from the chart below, the majority of BXMX's distribution is classified as ROC (91.3%), with SPXX and QQQX following suit at slightly higher and lower percentages. However, DIAX's ROC percentage is lower, sitting at 69.5%.
It is emphasized that these funds do not just return the capital; instead, they generate meaningful returns as shown by their consistently strong performance throughout the decade. The previous article explored the inner workings of this concept. In this discussion, the focus is placed on utilizing ROC as a signal for these funds.
Upon initial examination, ROC does not appear to be a reliable investment indicator. For instance, the fund with the lowest ROC percentage, DIAX, has consistently lagged behind BXMX, SPXX, and QQQX in terms of performance.
However, being critical of funds with higher ROC ratios, as seen in JCE, isn't ideal either. The smaller portion of ROC in JCE's distribution is in line with its leading performance in 2024, yielding a 24.6% return by this writing.
The explanation for JCE's superiority lies in its active management. Unlike other funds, which cannot adjust their stock holdings when the underlying stock prices fluctuate, JCE's management team has the ability to buy and sell stocks based on their analysis. As an example, they can decrease the fund's exposure to a rising stock price such as NVIDIA (NVDA), diverting investments into other strategic areas.
In conclusion, the key to maximizing profits and income in CEFs involves shifting focus from obsessively monitoring ROC. Instead, an investor should pay close attention to indicators such as portfolio quality, management, and the fund's performance history.
Additionally, identifying the type of fund is essential. JCE is not a covered-call fund, and it produces profits differently than covered-call funds. For instance, income generated by selling call options contributes to capital gains, whereas selling call options may result in losses when the stock prices decrease, thereby offsetting the capital gains.
Lastly, covered-call funds, particularly passively managed ones, tend to underperform over time. This research highlights the importance of disregarding the negative connotations associated with ROC, as it often plays an integral role in providing tax-free income for US shareholders. Utilizing funds that maximize ROC can be an effective strategy for offsetting gains or boosting income without increasing tax burdens. If well-planned, funds such as QQQX and SPXX may produce higher net profits than funds with higher returns on paper.
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more insightful income opportunities, click here to access our latest report “Indestructible Income: 5 Bargain Funds with Steady 8.6% Dividends.
Disclosure: none
In the context of retirement income planning, high yield funds like covered call funds can provide above-average income yields, such as the 7.2% average yield of covered-call funds, which is significantly higher than the 1.3% yield of the average S&P 500 stock.
Furthermore, retired investors can benefit from tax-free dividends generated by funds that utilize return of capital (ROC) effectively. For instance, Nuveen funds like BXMX, SPXX, and QQQX have a solid track record of surpassing the 100% mark in the last decade, with a majority of their distributions classified as ROC.
By focusing on indicators such as portfolio quality, management, and the fund's performance history, investors can maximize profits and income in closed-end funds (CEFs), even if a significant portion of their distribution is classified as ROC.
