Timing the Addition of a CEF to Your Portfolio

What if I told you that there's an exchange-traded investment that has averaged 8% annual distributions (paid monthly) throughout the current decade? What if I also told you that this closed-end fund (CEF) typically trades at about a 5% discount to its net asset value, but that it currently trades at a 10% discount.? Would you be intrigued?

Let's take the discussion one step further. What if this fund seeks current income that's, first and foremost, consistent with the preservation of capital? And what if it primarily invests in U.S. Government obligations like treasuries? Would the low level of traditional risk now be worth an 8% annualized return paid out monthly?

What if the fund in question has a 20-year track record of compounding at 9%? And what if the price of this fund had stayed in and around an $8 price target for the last 5 years, before the dramatic Q4 2008 financial crisis sent the price down to $6.50? Would a probable 15% appreciation make the current 9.25% yield even more attractive?

What if the fund has total net assets in excess of $3 billion, making it one of the largest fixed income CEFs in existence? And what if 88% of the debt in the portfolio is A-rated? Would these factors make the investment even more enticing? It would for me!

Let's review, restate and recalibrate:

1. This particular closed-end fund invests in U.S. government debt, mostly treasuries. Eighty-eight percent of the debt comes with an A rating. Clearly, the credit risk seems quite low.
2. With a beta of .45, this fund has less than 1/2 the risk of the U.S. equity market. Yet it is producing equity-like historical returns at 9% compounded. Obviously, this is a desirable risk-reward relationship.
3. This exchange-traded vehicle is trading at a 10% discount to the actual assets it holds. Moreover, it is trading at a 15% discount to its long-standing price point. Undoubtedly, the strong potential for capital appreciation may be added to the undeniable consistency of 8% annual (0.67% monthly) distributions.

In truth, I typically shy away from CEFs. They lack the transparency of ETFs/ETNs where one knows exactly what's inside. CEFs are also more expensive... a lot more expensive.

Nevertheless, there are exceptions... and the Alliance Bernstein Income Fund (ACG) is one of them. Even with an obscenely high 2.2% in net expenses (ETFs often run at about 0.5%), ACG is in the right place (troubled economy) at the right time (maximum fear).

The Alliance Bernstein Income Fund (ACG) has the liquidity of exchange-traded assets. So you can sell for a profit and/or use a trailing stop-loss to further mitigate risk. ACG is also large enough that the price execution is favorable for those who are concerned about an investment's bid/ask spread.

Tax-efficiency isn't a concern here either. ACG's turnover rate is about 13%.

Most importantly, the economic environment favors debt obligations... especially those that will be paid! This is a fund that'll be paying in spite of the credit crisis.

Best of all, a current yield of 9.2% gives you "sleep-ability" until credit is flowing freely. And at that future point, funds like the Alliance Bernstein Income Fund (ACG) will be trading 15% higher.

Again, CEFs rarely make the kind of sense that ETFs do. CEF costs are exorbitant. And you're counting on a fund manager to outperform a benchmark with reasonable risk... a feat that is rarely accomplished.

In this case, however, you have a yield that's greater than 7%. And it's not coming with the kind of risk that 7%+ yields are famous for. There's limited leverage (if any). And, the fund is trading at a price discount to its actual net asset value.

I would probably sell this CEF if I had pocketed a handsome 22%-25% in capital appreciation alone. And I'd put a stop-loss of 10%-12%, should the credit crisis become more incorrigible.

Yet, as long as you've got a low-risk asset that is producing at least 7.5% in cash flow, as long as you're not looking to lock in a gain or protect against an obscene loss, the Alliance Bernstein Income Fund's yield has all of the makings of a meal ticket.

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Disclosure Statement: ETF Expert is a web log ("blog") that makes the world of ETFs easier to understand. Pacific Park Financial, Inc., a Registered Investment Advisor with the SEC, may hold positions in the ETFs, mutual funds and/or index funds mentioned above. Investors who are interested in money management services may visit the Pacific Park Financial, Inc. web site.

Comments

[murf-o:]

Spent many years in the world of CEF investing, and it sounds good albeit the expenses.As previously mentioned,put a trailing stop on it if you enter......Nothings perfect.

2008 Dec 14 09:55 AM

[Alan Young:]

According to last quarterly report, the fund is leveraged to the max (-57% cash), while the T-bills it owns have run up in price parabolically. Yes, the bonds are safe, but their market value is not guaranteed, and can collapse precipitously. If this triggers a need to de-leverage, the dividend will be cut, as has happened to many other CEFs recently. Caveat emptor, as always.

2008 Dec 14 02:36 PM

[oldman:]

last years idea is next years flop. If you haven't noticed, treasuries are the bubble.

2008 Dec 14 05:28 PM

[jse17:]

Nicely discounted CEFs are one of the few venues where the “little guy” has a fighting chance. The low volume of most CEFs precludes hyperactive Hedge Fund manipulation and significant discounts more than offset active management fees.

BTW, a few CEFs actually have lower management fees than some of the newer, more avant- garde ETFs e.g., ADX and PEO. One of the classic, investor friendly CEF plays is buying ADX at a current 17% discount and vicariously purchasing PEO, the fund’s largest holding, at an additional 17% discount. The combined management fee for both funds is approximately 1.1%. (To quote the Rappers, “Can’t beat that!”)

I enjoy Gary’s work and look forward to his posts. Best of luck to all.

2008 Dec 15 09:21 AM

[Chamois16:]

The 2.2% expense ratio is very misleading. ACG's comparable ratio is 0.72%, well below normal for actively managed funds. ACG uses debt for funding its leverage rather than auction preferred shares (ARPS), so the interest on the $1B loan appears as "other interest" in the expense ratio.

Had ACG used ARPS, the required dividends would have shown up as liabilities on the balance sheet rather than an expense in the income statement.

This environment shows the advantage of active management, as treasuries lose favr.

Jan 25 09:01 AM

[Chamois16:]

Just to be clear. The 1.51% "other expense" is attributable to leverage costs

Annual Expense Ratios
As of 06/30/2008
ACG Common Shares
Management Fees 0.72%
Other Expenses 1.51%
Total 2.23%

Jan 25 09:17 AM