Equity CEFs: What To Do After The Bottom Falls Out

Includes: QQQ, SPY
by: Douglas Albo

The 2-day sell-off in equity based high yielding Closed-End funds (CEFs) has been brutal. In fact, you'd have to go back to August of 2011 and then all the way back to the bear market in 2008 to see moves like this. You then have to ask yourself why have the funds gotten hit this hard? Is it a buying opportunity or is this the start of something bigger?

The Canary In The Coal Mine

Equity CEFs can act a bit like a canary in the coal mine I have found. During the summer of 2007, when some rumblings about institutions having problems with mortgage backed securities first appeared, the markets quickly got over that and went on to all-time highs in the fall of 2007 ... October 9th to be exact. However, equity CEFs did not recover from the summer like the broader markets did and the funds continued to lag into the fall as their discounts widened. In hindsight, that could have been interpreted as a negative signal being given by equity CEFs and as we now know, the start of a bear market was just around the corner as mortgage backed securities were about to bring the financial markets to their knees.

Fast forward to the spring of 2009 when the markets were hitting their bear market lows ... March 9th to be exact, and equity CEFs were also under pressure during this time but not nearly as much as the fall of 2008 just 6-months earlier when many were hitting their all-time wide discounts over uncertainty of whether the TARP bailouts would be passed or not. So even though the broader markets were suffering their worst levels of the bear market in March of 2009, equity CEFs were holding up much better and, as we now know, the TARP bailouts approved by Congress were finally gaining traction in the market and a new bull market was born.

CEFs Tend To Lag Market Moves And Then Slingshot

There's a few other things I have learned about high-yielding equity CEFs over the years and one of the most important is that CEFs tend to lag the market moves up and down but once they get going, they tend to overshoot to the upside as well as the downside. Think of it as a sling shot affect. If they don't confirm the market move, like in the fall of 2007 when the market hit new highs or the spring of 2009 hit new lows, then that could be taken as a contrarian signal.

So what is the CEF market telling us now? Back in the fall of 2008, the financial well being of Wall Street was at risk and so it was not a surprise to see less liquid securities like CEFs sell off worse than the broader market averages even though these funds went on to dramatically outperform in 2009, as many went from all-time wide discounts to premium market prices in less than a year. Then in the summer of 2011, uncertainty over the global economic future of the eurozone and a slowdown in China led to another sharp sell-off of CEFs as well. Both of these situations involved dramatically heightened periods of uncertainty, and I just don't see that today. Now there is always uncertainty, and the fiscal cliff and higher taxes being negotiated in Washington is certainly adding to that increase in uncertainty, but I don't see this at the same level as other past crises despite the headline news.

All This Because Of A Dividend Tax Increase In 2013?

So if an increase in tax rates on high dividend yielding securities beginning in 2013 was not the only reason for the dramatic 2-day sell-off in these securities, then was something else at work here? I read an article yesterday which said that the reason why all the high yield oriented securities (CEFs, MLPs, REITs, high yield bond funds, etc.) were getting thrown out was because hedge funds were closing out their carry trades in which they leveraged up these high yielding securities. This makes a lot more sense to me and could explain why the funds have dropped so dramatically and are now back to their discount levels that we saw back at the end of 2011 when tax-loss selling brought most funds to their widest discounts since the bear market ended back in 2009.

I cannot say for sure whether the last two days was a capitulation, but I do know that when funds have been down for the better part of the month along with the broader markets and then are down 3% to 5% on successive days when their NAVs have held up much better, you have to figure that's as good a place to start initiating or adding to positions as any.

If hedge funds, which have not had a good year performance wise, have been forced to sell securities and take-off their carry trades to meet redemptions or for other reasons, then I believe this is a fantastic opportunity to buy equity CEFs at exceptionally wide discounts and enhanced yields. After all, where else are you going to put your money in a near zero interest rate environment? 8% to 11% market yields in equity CEFs is still a much better return than cash even if you have to pay higher taxes on those distributions ... which is not necessarily the case for high Return-of-Capital (ROC) funds, but that's another story.

Of course, you take on more risk investing in less liquid securities like equity CEFs, but I believe the sell-off over the past month and then the dramatic plunge over the last two days makes them an excellent risk/reward now for initiating or adding to positions. Historically, this has been a very good time to invest in these funds.

For those investors who are more risk averse, I would recommend shorting a large and liquid benchmark index like the SPDR S&P 500 Trust (NYSEARCA:SPY), the PowerShares NASDAQ-100 (NASDAQ:QQQ) or an international index to hedge your downside. If you have a retirement account, there are inverse S&P 500, NASDAQ and international securities offered by ProShares that you can buy that will go up when the correlated index goes down. I would not recommend the ultra inverse funds which offer 2X or 3X the moves of the index. I would also not hedge more than 1/3 of the total value of your long positions in these funds.

As for which equity CEF securities to invest in, I believe almost all of them offer good value right now. However, an article by Jim Fink that appeared on MarketWatch yesterday just confirms some of my favorites. You can read that article here.

Disclosure: I am short SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.