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FINRA Warns Investors to Look Behind Closed-End Fund Distribution Rates

Posted in Enforcement, FINRA Enforcement

FINRA issued an Investor Alert concerning closed-end fund distributions, principally to warn the public that a fund’s distributions might include a return of principal. Financial firms that create or distribute closed-end funds should take warning that FINRA will be looking at their practices in this regard.

The Alert entitled “Closed-End Fund Distributions: Where is the Money Coming From?” provides a primer in closed-end fund pricing, trading and distributions. It explains that closed-end funds are similar to mutual funds because they pool investors’ money to buy securities. Unlike mutual funds, which continuously sell and redeem shares, however, closed-end funds offer a fixed number of shares. Investors can purchase shares of a closed-end fund in an IPO or in the secondary market on an exchange. Listed shares of closed-end funds trade like stocks, with a price that is determined by the forces of supply and demand. The Alert explains that while closed-end fund shares historically trade at a discount to NAV, they can trade at a premium. According to FINRA, one reason for a premium might be that investors looking for a high distribution rate may be willing to pay a higher market price.

Closed-end funds usually pay distributions on a monthly or quarterly basis, according to FINRA. Distributions might include interest income, dividends and capital gains, and also might include a return of principal. FINRA cautioned that paying distributions from fund assets can create greater risk, since repayment of principal erodes the fund’s asset base that it uses to generate income.

The Alert also warns investors not to confuse this distribution rate with the fund’s total return or its yield. Indeed, some funds set a specific distribution rate regardless of income generated by the fund — a “managed distribution policy” — which increases the likelihood that the fund will have to return principal at some point. FINRA cautions investors to make sure to ask how the fund sets its distribution rate.

For broker-dealers, investment advisers and other financial entities involved in creating and selling closed-end funds, the implication of this release may be that FINRA is examining sales practices involving these funds. Indeed, the Investor Alert indicates that in using high distribution rates to attract investors, closed-end funds are similar to non-traded REITs (the subject of a recent FINRA sweep), business development companies (one of FINRA’s announced priorities for 2013) and master limited partnerships, all of which are entities that have been the focus of FINRA examination and enforcement efforts. Nobody should be surprised if FINRA’s next examination focus — or enforcement focus — is on these funds.