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With all the concern over taxes on dividend stocks and yield oriented funds going up beginning in 2013, why isn't anyone pointing out that investors can still receive 9%+ tax-exempt yields in non-leveraged high yielding equity based Closed-End Funds (CEFs), far higher than even their municipal bond CEF counterparts that use leverage. Then consider that the total return of many of these equity based CEFs over the years has soundly beaten that of the S&P 500 or other correlated benchmarks, and that doesn't even take into account the mostly tax-exempt distributions along the way.*

This is truly one of the great stories not being told in the financial markets. I don't want to hear anybody talk about the lack of good investment ideas or that the markets are rigged when there are high yielding CEFs being given away here at -9% to -14% market price discounts to their Net Asset Values (NAVs) while offering up to 11% yields, much of it tax-exempt.

A Little History To CEFs

So what's the catch and why do these funds trade at such wide discounts? Well, you almost have to go back to the beginning of when most of these equity CEFs went public from 2004 to 2007. That's because when CEFs went public, they had IPO prices typically at $15 or $20, but because of a sales credit, the NAV usually started about -5% lower. So right away, investors got off on the wrong foot with CEFs because the market price would usually drop to the NAV price and it often didn't stop there.

Another reason, I believe, is that most investors think CEFs are complicated and don't understand how they can possibly offer and maintain their high distributions and yields. Since equity CEFs can be prone to distribution cuts, I can see how this argument could carry weight. Then throw in equity CEFs that include a lot of Return-of-Capital (ROC) in their distributions, which many investors believe is just their investment getting handed back to them, and I suppose it's amazing that investors would hold their nose and buy equity CEFs at all.

But imagine for a moment if that ugly duckling could turn into a swan and that those high distributions and yields were not too good to be true. Imagine if these funds actually had sustainable distributions and had actually performed much better than investors thought. Would investors all of a sudden think these funds were, dare I say...undervalued? Well, part of my effort in writing these articles is to try and show investors that just may be the case, because most investors completely misunderstand how these equity based CEFs can possibly offer such high yields and returns without a catch. And they certainly don't trust funds that specialize in high Return-of-Capital distributions even though, as we'll see, this does not necessarily mean that the fund is simply giving you back your investment, i.e. the true definition of ROC, commonly called "destructive" ROC.

As we count off the days in December, we're once again seeing the end of the year swoon for many of these funds as investors sell off their shares and discounts become stretched. This is not unlike what happened last year when tax-loss selling brought many of these funds to their widest discounts since the bear market recovery in early 2009. This year it appears that the fiscal cliff and the concern over higher taxes on dividends is having much of the same affect. The other major reason could be the unwinding of the carry trade by institutions in anticipation of higher interest rates in 2013.

Whatever the reason, for high ROC funds that I follow and recommend, higher taxes on dividends should really be a non-event since most of their distributions are non-taxable anyway. This is presenting what I would consider an excellent opportunity for investors to snap up shares of funds at -9% to -14% market price discounts that offer 7%, 8% to even 9%+ tax-exempt yields. Below, I will tell you why these funds are much more advantageous than investors realize and how 2013 could be the year in which these funds significantly outperform their fixed-income CEF counterparts.

I've been writing articles on equity CEFs for the past two years trying to educate investors on the advantages, and also disadvantages of these funds. I'm hoping by putting this article under the "Income Investing Strategy" theme rather than just the "Closed-End Funds" theme, that I can start to reach a broader audience. So if I have any new readers, this is what I want to tell you. Equity CEFs are the greatest investment opportunity you will ever come across. Why? Because they are the most misunderstood investment class I know of. Most investors who own these stock based funds at $15 or $20 IPO prices swear off CEFs because they think these investments do nothing but go down. I'm here to tell you that is hogwash.

Why Equity CEF Total Return Performances Are Often Underestimated

Let me give you an example of two funds I have recommended in the past that represent two of the best funds in their class. What I want to show you first is the market price performances of these funds compared to their benchmark, the S&P 500. Both of these funds' portfolios include mostly large-cap US based stocks (S&P 500 stocks) though one fund also includes about 23% preferred stocks. The major difference between the funds however, is their income strategy to derive the income that they pass on to investors in the form of high distributions and yields. One income strategy, the leveraged strategy, works best in a strong up market and the other strategy, the option-income strategy, works best in a flat or trendless up and down market.

I will use the Nuveen Tax-Advantaged Dividend Growth fund (NYSE:JTD) to represent the leveraged income strategy (the one with the 23% preferred stocks which helps reduce volatility in a leveraged portfolio) and the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB) to represent the option-income strategy. I want to first show you why investors misunderstand these funds and immediately exclude them when they look just at their market price performances. Here are the two funds' market price performances if you simply graphed them against the S&P 500, as represented by the SPDR S&P 500 Trust fund (NYSEARCA:SPY), from the market high which was roughly at the end of the 3rd quarter 2007. So this graph represents a little over a 5-year time period.

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Based on this graph, it would look like these two funds, JTD (orange) and ETB (red), have lagged the S&P 500 (blue) pretty badly, especially ETB. But let's see what happens when you throw in their high distributions and look at the total return market price performances assuming reinvestment of all distributions along the way, including SPY's dividends. By the way, most quoted S&P 500 returns don't even include dividends, let alone on a reinvested basis.

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Big difference, huh? Now, all of a sudden, JTD and ETB are trouncing the S&P 500 when you reinvest the distributions. Though I don't necessarily reinvest distributions, this gives you an idea of why these funds' high distributions are masking the real total return performance and why investors may not be realizing what they are missing. Then consider for a fund like ETB, about 85% of the distributions along the way would not have been taxable. Even JTD shows about 53.6% of its distributions as ROC so far in 2012, meaning over half its distributions would not be taxable either.

Now let's look at the fund's total return performances from around the market lows at the end of the 1st quarter, 2009. This way, we can see how these funds performed against their benchmarks in all market environments, from a market high and from a market low.

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So here, a leveraged fund like JTD has skyrocketed 189% on a total return basis from around the market lows if you had reinvested the distributions. Even ETB, which is a very defensive option-income fund, has kept up with the S&P 500 which is a bit of a surprise since you would think the SPY would run away from a defensive option-income fund during a mostly up market period. Now before you go rushing out to buy JTD, remember leverage ups the volatility and risk in a fund whereas selling options like what ETB does lowers the volatility. If we flipped this around and showed just the bear market of 2008, ETB and especially ETB's NAV, would have held up far better than JTD or SPY. This is why I recommend that investors should have a balance of both fund strategies.

Now do you believe why investors may not be realizing what they are missing? I mean, where else can you find investors willing to part with high yielding funds that own nothing but blue chip domestic and international stocks at -9% to -14% discounts from their true net worth? Heck, the market's total return over the past 5-years hasn't even been close to 10% so that should give you an idea of how large a -9% to -15% discount really is. Most of these funds' NAVs, particularly the more defensive option-income funds, don't even move that much on a day to day basis so that should also give you perspective of how large these discounts are.

Other Advantages To Equity CEFs

Then add the fact that investors can receive windfall yields of 8% to 11% in a near zero interest rate environment, much of it tax-exempt. What do I mean by a windfall yield? The true yield that the fund pays is the NAV yield, so when you buy a fund at a discount, you pick up a windfall yield over and above what the fund is actually paying on its NAV. The larger the discount, the higher the windfall yield. It's a win-win situation when you buy CEFs at a discount, but do investors even recognize this? For the most part...no.

I mean, it's truly one of the most amazing things I see in the equity markets today. Now this doesn't mean that equity CEFs are not risky or that all equity CEFs are bargains because there are some pretty bad equity CEFs out there, ones that will continue to see NAV erosion despite their attractive yields. However, another advantage CEFs have over other investment classes is that there is no question as to the valuation of a fund if its holdings are priced accurately. If a fund is at a discount, it is undervalued...if it is at a premium, it is overvalued. It's as simple as that. Investors are free to speculate as to which funds are worth more or less than their value (or NAV more accurately), and many do speculate based on a fund's yield, distribution consistency, reputation or other factors. But the fact remains, unlike a stock whose valuation can be subjective based on price/earnings ratios or other subjective analysis, CEF valuations are indisputable as long as the portfolio holdings are correctly priced.

For more informed investors, it's this added valuation metric in CEFs that works in your favor over time because many investors don't even consider or even know about a fund's NAV. Many just assume they are buying or selling an ETF with no other valuation metric other than its market price. This is where an informed investor who performs due diligence on these funds has a real advantage. In the short run, a CEF's market price can go wherever investors take it, however, in the long run, a CEF's market price will follow a CEF's NAV just as certain as day follows night.

So how do you identify good and bad equity CEFs? I've written many articles that stressed that if investors want to know which funds to own and which funds to avoid, follow the NAV, taking into account the fund's distributions. What you will find when you follow a fund's NAV is that many of the negatives you hear about CEFs regarding distribution cuts or Return-of-Capital can actually be positives when you realize that distribution cuts can mean renewed NAV growth or that high ROC in distributions doesn't have to negatively impact total return performance. In fact, let's take a closer look at Return-of-Capital in equity CEFs since that is really the basis of this article.

How Do High Return-of-Capital Funds Work?

I want to get back to the word specialize, because that is exactly what many of these funds do when they offer high yields of mostly ROC in their distributions. High ROC funds almost all come from the option-income funds and if pure leveraged funds have a lot of ROC in their distributions, that should be a much bigger red flag. Nonetheless, there's been a lot of controversy about whether option-income funds work or not because they all have diminishing NAVs historically and they all have had distribution cuts. Let me tell you right now, option-income funds work.

The main reason why option-income funds work is because options are time depreciating assets and time works in your favor when you sell options in a flat or trendless up and down market. It's the buyer of the option that takes on the much greater risk. However, in a strong up market, short option positions can become a liability and the fund may close out their option contracts at a realized loss before expiration. That is exactly what option-income funds do in a strong up market and that realized option loss can be designated as ROC even if the value of the fund (as reflected in the NAV) has risen due to unrealized appreciation of the fund's stock holdings.

Conversely, those short options become money in the bank in a down market and offset the full depreciation of the fund's stock holdings. This is why option-income funds are much more defensive than leveraged funds by nature. But in such a down market scenario, the fund may be able to sell losing stock positions and realize a loss here as well. That loss can be added to any carryover loss the fund already has which can be offset against those option gains. So this is how an option-income fund can realize losses no matter which way the market is going. And this is how these funds specialize in generating high ROC in their distributions even if the fund may be appreciating in value.

So why have option-income funds been cutting their distributions over the past couple years in a mostly up market? Mostly because option premium has been coming down with interest rates and these funds haven't been able to generate as much income as in the past. Then combine that with depressed NAVs after the bear market of 2008, and the funds didn't have as high a capital base to sell options against either. As a result, many funds were saddled with 12%+ NAV yields after the bear market which they couldn't maintain even when the markets were recovering. Remember, option-income funds' NAVs will not capture all of a ramp-up market like we saw during the market recovery from early 2009. Thus began a series of distribution cuts for most option-income funds beginning in 2010. The good news is that virtually all the option-income funds I follow have reduced their NAV yields from 12%+ to a much more manageable 8% to 10%, right around their inception NAV yield levels. This should dramatically reduce the need for further cuts but this is also a good lesson on why you need to keep an eye on NAV yields if they drift back up to 12%+.

Why Option Income Is Better Than Dividend Income

One subtle point that investors are missing with funds that depend on options for income vs. funds that depend on portfolio dividends is that options don't reduce the value of the portfolio whereas dividends do. In other words, selling options against a portfolio of stocks may limit the upside of the portfolio, but it doesn't reduce the value of the portfolio. This is similar to interest payments from bonds and fixed income investments. When a bond issues an interest payment, the bond itself does not go down in price. However, when a stock goes ex-dividend, the stock price is reduced by the value of the dividend.

This is a very subtle difference that can make a huge difference over time. Of course, all stock and bond funds, including ETFs, CEFs and mutual funds, are reduced by their distributions when they go ex-dividend, but here I am talking about the actual holdings of the funds. One only has to look at CEFs that use a "dividend harvest" strategy to see what the cost of stock dividends have been to the fund's NAV over time. Trust me, these are not funds you want to own and I have pointed that out time and time again. But that's another story.

Conclusion

Here are the option-income funds I follow sorted by the percent of Return-of-Capital in their distributions for 2012, shown in the red "ROC Percent" column. I have also highlighted in green funds which have NAV total return performances over 10% year-to-date through December 14, 2012. Keep in mind that these ROC percents are estimates by the fund sponsors, and the actual non-dividend distribution ROC amounts will be reflected on an investor's year-end 1099 for taxable accounts.

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One thing I want you to notice is that there is really no correlation between funds with high ROC in their distributions and a fund's total return NAV performance. I think this would surprise a lot of investors, but this backs up my statement that high ROC tells you very little about how a fund is performing, at least at the NAV level. Unfortunately, funds with high ROC tend to trade at some of the widest market price discounts, but that is where the opportunity is for more informed investors who recognize that it is not as simple as rating funds by their ROC percent.

Note: I was not able to include all of the option-income funds in a screen shot as there are some option-income funds that have no ROC in their distributions, just as there are leveraged CEFs that DO have ROC in their distributions.

Not all of the high ROC funds shown in the table I would recommend and this listing is purely for sorting option-income CEFs by their ROC percentage. To get a rough tax-exempt yield of each fund, you would just need to multiply the ROC percent by the fund's current market yield (information is as of December 14th, 2012). I believe for income investors looking for tax-exempt income*, the high ROC funds I recommend can be an excellent addition to their portfolios. Though obviously, these funds are a bit more complex and a bit more risky than simply cutting coupons from muni bonds and cashing in your tax-free interest payments, would you agree that this is still one of the great stories not being told in the financial markets today? I would.

*For purposes of this article, tax-exempt is defined as that part of a fund's distribution that is classified as Return-of-Capital , which is non-taxable in the period received, though an investor would need to lower their cost basis by the ROC amount for purposes of determining any future capital gain or loss. Please consult with a tax professional before making any investment decisions based on this article as I am not an accountant or tax professional.

Source: Equity CEFs: 9% Tax-Exempt Yields Being Given Away - The Greatest Story Not Being Told

Additional disclosure: Short SPY