It’s been a tough year for closed-end fund (CEF) investors as risk asset volatility, a slump in credit, and general unease over the Federal Reserve’s long anticipated rate increase has widened discounts.  However, many CEFs are still awarding investors with large end-of-year special distributions.  In a CEF wrapper, a fund is forced to distribute any underlying portfolio earnings above and beyond its stated distribution policy to avoid paying taxes at the fund level.

This income gap is often referred to as undistributed net investment income (UNII).  Furthermore, since many funds employ rather conservative board-mandated policies, they dictate that fund earnings should be well in excess of regular monthly or quarterly distributions to avoid dividend cuts.

I am often asked about whether these large distributions make for good fund management policies, and whether or not the fund is sand bagging its own performance potential. The fact of the matter is that many funds yield in the low to mid-teens when the end of year distributions are calculated back in.So why would a board intentionally maintain a lower distribution policy when additional yield thirsty investors could be lured into purchasing the fund as a result of a larger monthly cash flow?

Naturally, there are several schools of thought, but if fiduciary duty has taught me anything, it’s that board members error on the side of caution. They want to stay employed, avoid arbitration, buffer active management changes, and avoid policies that could ultimately lead to dividend cuts or discount widening.

Secondarily, there is an element of behavioral finance to special dividends, because the average Joe isn’t consistently forecasting and calculating UNII from the semi annual reports. So from that perspective alone, an announcement of a large special distribution is a welcoming sign that the fund is doing well, which might attract more capital this time of year from IRA contributions or other sources.