Cha Ching, Cha Ching! Money Doesn’t Grow on Trees but Uninformed Closed-End Fund Investors May Incorrectly Think So.

By Christopher Pugh, Fall 2014 Student Intern

money treeMany people looking to add income to their investment portfolio are considering closed-end funds. Purported benefits of closed-end funds include distribution rates higher than the income from mutual funds or stocks. But be aware: distribution rates are not the same as total returns. Importantly, investors should always ask two questions. Where the distributed income comes from? And how will that income effect my taxes?

Distribution Rates: Where Does the Money Come From?

FINRA recently issued an investor alert warning investors to be aware of the details of a closed-end funds’ distribution rates and sources. A closed-end fund is similar to a mutual fund because it pools money from investors to buy stocks and securities, then the fund professionally manages the investments. But unlike a mutual fund, a closed-end fund can return a portion of the investor’s principal investment to meet its minimum distribution requirements. So, while the mandatory distributions are an attractive feature of closed-end funds, it can also be risky because paying the required distributions out of the fund’s principal will erode its asset base, which in turn lowers the share price. Of course, if the fund makes strong investments that return profits, then there would be no need to return the capital to meet the distribution requirements. Accordingly, it is important that investors know where the money is coming from and how the source of the money effects the bottom line of the fund’s share price.

Taxing Questions: Will a Closed-End Fund Effect My Taxes?

Another attractive feature of closed-end funds is that they allow for “pass-through” income, that is, the fund does not pay the taxes on the income but allows the whole of the income to “pass-through” to the investor thus avoiding “double taxation.” It is then the investor’s responsibility to report that income from the investment on their tax return. This can change an investor’s tax treatment, so it is important for investors to understand how this “pass-through” income may change their tax liability.

TIP: Closed-end funds aren’t the only investment that offers distribution rates to attract investors. When considering an investment in non-traded real estate investment trusts (REITs), business development companies (BDCs) or master limited partnerships (MLPs), you should ask the same question about distributions.

Additional Resources

Alternative Funds Are Not Your Typical Mutual Funds