The Closed-End Fund Trifecta: How To Analyze A CEF

by: John Cole Scott

At CEFA, we consider three important details when doing a primary review of a closed-end fund (CEF), whether it is currently in one of our client portfolios or being considered as part of a portfolio in the future. We track almost 70 data points per week per U.S.-listed CEF with "CEFA's Closed-End Fund Universe Report" (CEFU). The key areas we suggest investors or investment professionals monitor are the following: Entry Point Risk, Dividend Risk and NAV Performance.

1. Entry Point Risk - The NAV vs. Market Price for a CEF

We find it is important to not only understand the current discount or premium (disc/prm) on an absolute basis (amount + or - from zero), but also compare the disc/prm to itself historically and to its peers. CEFA uses a 90 day relative discount or the current disc/prm vs. the previous 90 day average disc/prm. We also compare funds on the 1 year z-statistic, which is the current disc/prm vs. the 52 week average disc/prm then divided by the volatility (or standard deviation) of the discount. A third relative measure of a disc/prem would be the discount range, essentially plotting the current disc/prm as a percentage between the 52 week disc high and low. The goal for these data points is to help determine if a fund is currently over or under priced.

Entry Point Risk - Rules of Thumb

  • We generally like an absolute discount over an absolute premium, but recommend one reviews Dividend Risk and NAV Performance closely before simply buying a dividend yield or deep discount.
  • Having a negative 90 Day Relative Discount means buying a fund at a lower than average discount. This is often a good place to buy into a fund, as long as it has positive fundamentals, but again, we suggest you have an understanding of the dividend's security and the manager's NAV performance before making any buy/sell decisions.
  • A 1-year Z-Stat between -1 and +1 is within one standard deviation of the discount/premium range for the previous year. This is a relatively normal place for a disc/prm to fall. When the Z-Stat gets over +1.5 or -1.5, the current relationship starts to gain statistical significance. Over +/- 2, or especially +/- 3, are rare occurrences. However, a wide Z-Stat does not scream a buy or sell without review of any dividend policy changes that might have occurred recently, as well as NAV performance. For perspective, as of January 11, 2013, out of 598 CEFs, according to our CEFU report, there were 66 CEFs with a Z-Stat over +2 and 0 CEFs with a Z-Stat below -2 (PCF is at -1.99).
  • When looking at a fund's disc/prm, we find it useful to compare it against its peer-average disc/prm, as investors who regularly analyze CEFs are often looking to a good relative discount, and finding a CEF below its peer-average discount can be a way of identifying a fund with modest down-side protections and above-average upside potential. However, no data can guarantee future performance, relative or absolute.

2. Dividend Risk/Security

The average closed-end fund is currently showing a 6.3% annualized forward looking distribution yield (CEFU as of 1/11/13), making it clear that the dividend is often a significant component for a CEF's total return. For the 598 current CEFs, 76% have distribution yields over 5%. There are more than a few CEFs that have dividend levels CEFA considers ridiculous (usually 10+%) and unsustainable going forward. Here are a few ways to identify those funds.

Step 1 - We suggest you take a fund distribution amount and take out the impact of a discount or premium. For example, if a CEF has a 10 cents per share expected annualized dividend and a NAV of $10, the fund has a NAV Yield of 10% (often different than market price yield). The second analysis to do is to remove the amount of leverage from the yield for comparison. If a fund has 33% leverage, then you need to remove 33% of the NAV yield to come to a NAV leverage adjusted distribution yield. In the previous case, this would mean an approximate 6.67% leveraged adjusted NAV yield. Next, review the portfolio holdings and allocations to decide if the distribution is realistic and sustainable over time.

Step 2 - For equity CEFs, look at the percentage of the dividend recently reported as Return of Capital (ROC). Return of Capital is not always bad and sometimes simply an accounting measure, especially for Master Limited Partnerships (MLPs), Real Estate Investment Trusts (REITs), option premium (Covered Call/Buy-Write Funds). It can also be caused by a delayed sale from the fund's portfolio by the manager. It is also important to note that the final dividend breakdowns for tax purposes will not be 100% accurate until January of the following year, when the 1099 DIV form is generated by the fund for its shareholders.

We break-out RoC and define the destructive RoC, Return of YOUR Principal (ROP). When this occurs, it is essentially the fund charging a fee on money it plans to return to you as a dividend. Outside of pure trading reasons vs. investing reasons, we see no reason to buy a CEF with a consistent history of significant RoP in its monthly or quarterly dividend payments. We suggest looking at how peer funds have classified their dividend break-down in their section 19 notices or regular press releases.

We care more about recent announcements, and we use a 90 day look-back for calculating the percentage of the dividend expected to be RoC. It is worth noting dividends categorized as RoC, vs. income or capital gains, are not taxable, but write down your cost basis on the CEF and would be considered tax-deferred. When a security is sold, you would need to account for this reduced cost basis when calculating capital gains.

Step 3 - For fixed-income CEFs, we like to look at two data points: 1. The Earnings Coverage Ratio and 2. Relative Undistributed Net Investment Income (UNII) -- when negative, it is often called "over-distributed net investment income." In most cases, to purchase a bond CEF, we require it to be earning its distribution to avoid the increased risk of a potential dividend cut. We also like a fund to have a 8-17% positive relative UNII, which equals 1-2 months of income cushion on the fund's balance sheet. However, it is important to note that a small positive Rel UNII cushion could be eroding to a deficit, and a small to moderate Rel UNII deficit could be building towards a surplus. That is why it is important to monitor the UNII and Earnings Trend and not simply the absolute level.

If the data is only 1-4 months old, then we consider it to be "fresh." We discount heavily the data from funds with earnings/UNII data 5 months or older. More and more bond funds are offering this data monthly, and we suggest when you speak to any investor relations contacts at a CEF not currently doing this, you let them know monthly earnings and UNII figures are a significant factor in your fund selection process. Most quarters, 85%-90% of the funds announce dividend "maintains" vs. "increases" or "decreases." It is the roughly 4-8% dividend cut announcements we are trying to help you avoid by understanding and monitoring this data for CEFs.

Dividend Risk - Rules of Thumb

  • No single data point can guarantee a dividend increase or decrease. It only can suggest where risk or opportunity might lie. Only a fund's Board of Directors/Trustees can make dividend changes.
  • Even if UNII or Earnings are negative or lower than the dividend level, remember to look at how peer funds are doing for the same data points to give a more realistic analysis.
  • The current level of a fund's discount or premium can also help identify how much anticipated risk is built into a fund's distribution policy or level.
  • Do not forget that an investor's performance is a combination of "yield" and "capital appreciation or loss." Both factors need to be combined for any accurate comparisons.
  • Another important concept to note with UNII data is that it shows a fund's life-to-date balance and can be impacted from accounting and IRS adjustments over time. The older a fund, the more import the trend is vs. the absolute level of UNII.

3. Net Asset Value Performance

A closed-end fund is best described as three things:

1. A near permanent number of shares without daily in/out flows (open-end funds) or the involvement of creation units (exchange-traded funds).
2. Active portfolio management involving portfolio managers and a team of analysts vs. a passive index or a pre-determined formula.
3. Investor liquidity or the ability daily to have the shares trade on a U.S. exchange (NYSE/NASDAQ).

While all CEF shareholders buy and sell at market prices on exchanges, we find it best to track a portfolio manager and their team using NAV performance. This takes their cost into account vs. the investments that they purchase or sell over time. Even though there are funds with large differences in how the market price trades vs. the NAV movement, as we track with 90 day NAV/Mkt Price correlation figures, we have noticed that over the long-term, a CEF's market price eventually follows its NAV trend and should be monitored closely.

NAV Performance - Rules of Thumb

  • We suggest investors look at a CEF's NAV performance and compare it to their peer-funds and a tracking index. This is a great way to confirm the fund is a good investment vs. discount or dividend hype driving the market price.
  • CEFA doesn't dwell on expense ratios, as we feel, growing capital from its current level is far more important than a 0.25% (only an example) difference in friction on the portfolio. NAV calculations take out the fund's operating and management costs in order to compare funds on a net basis.
  • We do not completely ignore expense ratios, but it is a secondary factor in our CEF research process.

Conclusion: While there are many factors to consider, we feel if you can get a handle on these three main concepts (Entry Point Risk, Dividend Risk and NAV Performance), you are likely to have more success in a CEF oriented portfolio vs. the masses. Remember with CEFs, you only need to be faster and smarter than the average individual investor or financial advisor, as it is hard for the billion-dollar blocks of capital to use CEFs due to liquidity concerns.

According to the Investment Company Institute's (ICI) 2011 data, only 1.8% of U.S. households own shares in closed-end funds. We believe this fact alone should give serious, disciplined investors or investment professionals a reason to learn more about CEFs and how to understand their risks and benefits. Armed with this knowledge, you have the opportunity to find "above normal" yield and performance.

A closed-end fund is a structure around an investment objective. While CEFs can be inefficient and under-utilized, we believe they provide great opportunity for investors. However, they are not a magical formula to avoid risk and performance loss. Also, as data on funds or their peers is updated regularly, they are not considered by our firm to be the best buy-and-hold investment vehicles. Swapping funds in a CEF based portfolio should be considered a normal part of your portfolio management process.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.