Cornerstone Funds' Payout Not What It Appears
A lot of closed-end funds have gone on fire sale since the recent market rout. But there are two that still command a premium of more than 50% over the value of their assets, even though their performance has consistently lagged the S&P 500.
The big attraction of $51 million (CRF)Cornerstone Total Return (CRF) and the $131 million (CLM)Cornerstone Strategic Value(CLM) appears to be their hefty payouts. CLM currently distributes 9.3 cents per share each month, while CRF pays out 17.8 cents per share each month. That works out to a yield of 12.47% and 11.76%, respectively, as of Aug. 17.
Unlike open-end funds, which issue and redeem shares daily at net asset value, closed-end funds issue a fixed number of shares that trade on an exchange. It's not unusual for share prices to move out of line with net asset value when demand is weak or strong. In the case of CRF, investors are paying $1.58 for $1.00 of assets, while investors in CLM are paying $1.56 for $1.00 of assets.
What shareholders may not realize is that most of the distributions they are receiving represent a return of their principal investment, rather than investment income. More than 95% of the total distribution CRF paid between 2002 and 2006 was simply returning the original money that investors had put into the fund, what's known as return-on-capital, according to filings with the Securities and Exchange Commission. Excluding 2005, when yield came from net realized gain on investments, over 96% of CLM's yield was return-of-capital over the same period.While this aggressive dividend policy has boosted the funds' share prices, it is also eroding their net asset values, given their lackluster returns: Cornerstone Total Return's NAV per share had fallen to $8.95 on Aug. 17 from $18.28 on Dec. 31, 2001, according to the information in the fund's filings. Cornerstone Strategic Value's NAV fell to $4.78 per share from $11.31 per share over the same period. Shareholders of the Cornerstone funds "are playing a dangerous game of Old Maid," says David Tepper, of Tepper Capital Management, an investment firm that specializes in closed-end funds. Repeated calls to Cornerstone Advisors last week were not returned. While some investors who paid a premium for the funds may be getting shortchanged, the distribution policy benefits big players who bought at a discount and can now sell into the funds' strength. Ron Olin, an activist investor who wrestled control of the two funds from former management back in 1998, has steadily been reducing his holdings since the distribution policy was introduced in January 2002. Most other closed-end funds that adopt such an agressive distribution policy are trying to close a persistent discount in their share prices to net asset value. They must lobby the SEC in order to use capital gains to make payouts more often than once a year, and they are required to adequately disclose that the distributions are not necessarily income or yield. Initially, that was the case with the two Cornerstone funds -- when they first adopted these policies, they traded at discounts to NAV. But the two funds have continued to pay out more than they earn, even though they trade at steep premiums. Tepper says that Cornerstone Advisors is much more forthcoming about source of the distributed funds than it was in the past, but he wonders if investors bother to read the fine print. "You could offer these funds as evidence that you can fool some of the people all of the time," he says. Cornerstone Total Return said in early August that monthly distributions in 2008 would continue to payout at 21% of NAV as of Oct. 30. It disclosed that "the fund's distribution will consist either of (1) earnings, (2) capital gains, or (3) return-of-capital, or some combination of one or more of the above ... these distributions should not be confused with yield or investment return on the fund's portfolio." What's left unsaid is how balanced that combination tends to be. According to the Cornerstone Total Return's annual report in 2006, it paid total dividends and distributions of $2.11 per share to investors during the year, of which only 9 cents was net investment income and $2.02 was returned capital. The Closed-End Fund Association's Web site lists the funds' yield based on income alone, giving a better idea of how much of the payouts are a return-of-capital. As of Aug. 17, CLM offered an annualized distribution yield of 12.47%, but just 0.85% was income. Of CRF's 11.76% yield on that date, 0.82% was income only. "As long as investors know that it's a managed distribution plan, if they're not concerned with income and just want to draw down on their account after it's accrued so much in capital gains, regularly paying themselves back, that's great," Tom Roseen, senior research analyst at Lipper. "But if they're not aware of the pitfalls of a managed distribution plan, they may be being spoofed a little bit." But Tepper says investors would do better buying an index fund an index fund and simply selling 10% of their shares each year to get a 10% "yield." "They would also be better off buying a well-managed CEF with a history of good performance -- such as (GAM)General American Investors (GAM) or (CET)Central Securities Corp (CET) -- that is selling at a 10% or more discount to NAV," he says.
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