I keep seeing regular explainers on SA about ROC. You would think that if the explainers were working there wouldn’t have to be regular explainers. In any case, the take is usually along these lines – Not all ROC is bad. There is destructive and constructive ROC and only the destructive ROC is bad. I don’t know who came up with the term destructive ROC but they single-handedly injected a ton of confusion into the market. The idea is that ROC is destructive i.e. bad if the distribution is not covered by either fund income or capital gains (unrealized or realized). In other words, if the NAV is moving lower over time, ROC is destructive and otherwise it’s constructive. 

The problem with this is that the NAV can move around for a whole host of different reasons. For example, fixed-income funds have enjoyed the support of falling yields over the last decade which has buoyed NAVs. So there are many funds that have been returning ROC but have not seen a move lower in NAVs due to the persistent fall in yields. This support is unlikely to materialize over the next decade (unless yields go negative) and so the same fund that had been distributing constructive ROC will now be distributing destructive ROC. The fund that hasn’t changed anything could see its ROC move from constructive to destructive which is a weird thing to happen and doesn’t really help to enlighten investors. 

The situation with equity funds is even worse because of their higher NAV volatility. Imagine a situation where we see successive annual equity returns of -5% and +5%. In this situation the fund’s NAV would move lower one year and higher the next. So it would be alternatively constructive and destructive ROC simply by what happened in markets that year. Labeling one year constructive ROC and the next destructive ROC doesn’t seem like it provides a lot of insight into what the fund is doing. 

Secondly, funds can easily change ROC to something else. Outside of extreme markets, funds will always have some unrealized gains. So a fund that is overdistributing relative to its income but doesn’t want to show ROC will just sell assets with unrealized gains to distribute realized gains rather than ROC. And while many investors will find this more palatable than seeing ROC it’s actually a worse outcome for investors as it creates a potential tax event. 

Overall, the concept of destructive and constructive ROC is another attempt to dumb things down and, as with other instances, it fails. The reality is investors should not co-mingle income, distributions and moves in the NAVs because these are very distinct things and should be looked at separately. 

This doesn’t mean that investors shouldn’t pay attention to the trend in the NAV (there is a column that does just that in the Sector View tab of the CEF Tool!) but the destructive ROC concept just tries to do too many things which makes it far from useful.

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