Return of capital (ROC) is a concept often misunderstood by investors, particularly those drawn to the high yields offered by closed-end funds (CEFs). While some view ROC with suspicion, believing it represents a return of their initial investment rather than genuine profit, it can actually be a significant advantage, especially in the context of high-quality CEFs. This analysis will delve into the nuances of ROC, using five Nuveen funds as illustrative examples, to demonstrate how it can contribute to substantial overall returns while offering tax advantages.
The Nuveen funds chosen for this analysis represent a mix of investment strategies. Four of them – Nuveen S&P 500 Buy-Write Income Fund (BXMX), Nuveen Dow 30 Dynamic Overwrite Fund (DIAX), Nuveen S&P 500 Dynamic Overwrite Fund (SPXX), and Nuveen NASDAQ 100 Dynamic Overwrite Fund (QQQX) – are covered-call funds. These funds hold the stocks of the index they track and generate income by selling call options on a portion of their holdings. This strategy effectively converts market volatility into income for investors, offering attractive yields often significantly higher than market averages. The fifth fund, Nuveen Core Equity Alpha Fund (JCE), is actively managed, allowing its managers greater flexibility in buying and selling stocks based on their market outlook.
Over the past decade, these funds have demonstrated varied performance. BXMX, SPXX, and QQQX have all delivered returns exceeding 100%, while DIAX, tracking the more slowly growing Dow Jones Industrial Average, has lagged with an 86.4% return. Despite these performance differences, these funds share a common characteristic: a substantial portion of their distributions are classified as ROC. This seemingly paradoxical situation – high returns coupled with high ROC – underscores the need for a deeper understanding of how ROC functions. It’s crucial not to equate high ROC with poor performance, as DIAX, the laggard in terms of overall returns, has the lowest ROC ratio among the covered-call funds.
A comparison of JCE with the covered-call funds further highlights the complexity of ROC. JCE, with its actively managed strategy and lower ROC ratio, has outperformed the others, particularly in 2024. This superior performance stems from the fund’s active management, allowing it to strategically adjust its holdings based on market conditions and individual stock performance. For instance, JCE can reduce its exposure to a high-flying stock like NVIDIA, while a passively managed covered-call fund like QQQX would be obligated to increase its NVIDIA holdings as the stock’s weight in the NASDAQ 100 index increases.
Therefore, focusing solely on the ROC percentage can be misleading. The key to successful CEF investing lies in evaluating a broader range of factors, including portfolio quality, management expertise, and historical performance. Different fund types, such as actively managed funds versus covered-call funds, generate returns through distinct mechanisms. Covered-call funds, by their nature, recognize income from selling call options as capital gains, which can sometimes be offset by losses incurred when underlying stocks are called away. This dynamic can explain why covered-call funds, particularly passively managed ones, may underperform over the long term compared to actively managed funds.
The critical takeaway for investors is to avoid fixating on ROC percentages. Much of the discussion surrounding ROC is based on misconceptions. Instead of viewing it with apprehension, investors should recognize that ROC often represents a tax advantage, effectively offering tax-free income for US shareholders. This can be particularly beneficial for offsetting gains elsewhere in a portfolio or boosting income without increasing the tax burden. This tax advantage can, in some cases, lead to a higher net profit for investors despite lower overall returns on paper. For instance, funds like QQQX and SPXX, despite slightly trailing JCE in overall returns, might ultimately deliver a higher net profit due to the tax benefits associated with their higher ROC distributions.
In summary, understanding the nature of ROC is crucial for evaluating CEF investments. While high ROC percentages might initially raise concerns, they often represent a tax-advantaged return of investment earnings, not a depletion of principal. Focusing on a broader set of factors, including fund management strategy, portfolio quality, and historical performance, provides a more comprehensive assessment of a CEF’s potential. By recognizing the potential benefits of ROC, investors can leverage this often-misunderstood aspect of CEF investing to enhance their overall portfolio returns and minimize tax liabilities. Blindly relying on ROC percentages without considering the broader context can lead to inaccurate assessments and missed opportunities. Instead, a nuanced understanding of ROC and its implications, coupled with a holistic evaluation of the fund’s characteristics, is essential for informed CEF investment decisions. This approach allows investors to maximize their after-tax returns and effectively integrate CEFs into a diversified investment strategy.
