CEFs in Cyclical Bottoming Process: Two Recovery Plays

 |  Includes: FOF, GCE
by: Joe Eqcome

Conclusion: After a six year relative slide in the Claymore CEF Index, closed end funds (CEF) may be setting up for a “run”. It appears CEFs may have completed a bottoming process relative to the S&P 500 during late 2008 and is now bumping up against its resistance level. In the previous recovery, CEFs outperformed the S&P 500 early in the market cycle. Cohen & Steers Closed-End Opportunity Fund (NYSE:FOF) may be an interesting single stock play on a CEF “break out”. FOF has a high correlation with the CEF indices.

Summary: The chart below compares the indexed spread, i.e. difference, between the Claymore CEF Index (daily pricing) and the SPDR S&P 500 ETF (NYSEARCA:SPY) as of the stock market’s previous cyclical trough of Oct ’02. As the trend line indicates, on average CEFs have slid for over 6 years on a relative basis. This performance has been a source of despair for most CEF investors and a cause of capitulation by others.

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Reasons for CEFs' Underperformance: There may be several indigenous reasons for CEFs’ relative share price underperformance during the past stock market cycle: CEFs pay-out their earnings in the form of distributions and don’t get the benefit of reinvestment (in some cases CEFs pay-out capital to maintain managed distribution policies); a significant portion of the CEF market segment is fixed income (about 50% by fund) with a low stock beta. More recently, CEFs, categorized as financial stocks, may have suffered along with the financial sector. Additionally, CEFs have been tarred by the auction rate preferred stock market seizure that began early last year, and in some cases were by regulation prevented from making dividend payments—a “no-no” in the equity income world.

Two Single Stock CEF Recovery Plays: No honest broker knows if “the turn” in equities is imminent, or whether CEFs will again initially outperform the S&P 500. However, such information may come in handy when in fact the “turn” is made.

Cohen & Steers CEF Opportunity Fund (FOF) is my preference due to its high correlation to the Claymore CEF Index (R^2=.9888) (see chart below); its CEF structure; no current leverage; trades at a discount; average daily volume of 85,000 shares. Ironically, the second choice is The Claymore CEF Index Linked GS Connect ETN (NYSEARCA:GCE). GCE is designed to track the Claymore CEF Index used in this analysis. The reasons for being second choice are: only $21 million in net assets; trades on average of a 1,000 shares per day; priced at par; ETN embodies counterparty risks.

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Disclosure: Author holds a long position in FOF