CEFs in Cyclical Bottoming Process: Two Recovery Plays

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 (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 (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.

click to enlarge images

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 (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.

Disclosure: Author holds a long position in FOF

Comments

[Alan Young:]

I don't understand why you would lump all CEFs together as if they were a single sector. Muni bond CEFs will perform (with some variation) as the muni market does, which will be quite different from junk-bond or emerging-market CEFs.

There are cyclical reasons for variations in premiums and discounts, but if that's your point it could be a lot clearer.

Mar 26 01:20 PM

[Joe Eqcome:]

Asian-

I once asked a famous institutional investors how he had time to research individual financial stocks prior to purchase during the savings & loan stock market recover. His response was he didn’t. He said he bought the whole group and kicked the stocks out he didn’t like after he owned them. He added that he would have missed a powerful part of the segment’s initial market movement had he not proceeded in that fashion.

The contention of the article—rightly or wrongly—is that we may be on a verge of a “run” in the closed end fund segment for factors articulated therein. The proposition is that investors may be able to capture the early part of that powerful advance by participating in the highlighted stocks designed to capture the diversified characteristics of a diversified CEF Index.

While your point regarding the diversity of the CEF fund types is true, fund types are sub-sectors within the CEF market segment. Closed end funds are in fact a single market segment bounded by the regulations of the “40’s Act” that created them.

Early in a stock recovery cycle for any particular market segment—be it financials, industrials, REITs, techs, etc., all boats will rise in a fairly indiscriminate fashion. My task was to make its simple for less knowledgeable investors to participate in that early price movement through a single stock purchase.

It is during the subsequent phases of the CEF market cycle that knowledgeable investors like you will be needed to help us parse the various fund types.

Joe Eqcome

Mar 26 06:42 PM

[JCCIII:]

Joe. A quick check at ETFConnect shows FOF has a yield of 12.71% (based on a $0.27 quarterly distribution), a discount of 5.66%, and an expense ratio of 0.95% (all for data as of 3/26/09). It appears FOF went from a monthly distribution ($0.1175) to quarterly distribution ($0.27). While the yield looks good, is any of the distribution return of capital? Also, the 0.95% expense ration is, I assume, in addition to the expenses charged by the funds that it holds. Do you have a number for the total expense ration? Finally, the discount appears greater than the average of the past 12 months, so one would get a bargain if purchased now. Thanks very much. JCarroll

Mar 27 02:19 PM

[Joe Eqcome:]

JCarroll

According to FOF’s recent annual report, its net investment income was $.74 per share. So, its current distribution of $1.08 is 146% of its recurring income. The balance of ‘08’s distribution was a “return-of-capital” which diminishes its NAV per share by a similar amount.

If you based its future annual distributions on its current net investment income, it would be around a 9% distribution yield. That would be the yield on which I’d base my investment decision.

You’re correct regarding FOF’s expense ratio being in addition to that of the CEFs it holds. While I don’t have the exact expense ratio for its holdings, the average for the CEF market segment is 1.5%.(You should note that management expenses of its portfolio holdings are already imputed into their NAV calculations.)

Discounts vary with investor sentiment and market cycles and tend to be the widest at market bottoms. Typically, discounts tend to narrow when the market "turns-up" and accelerates the share price appreciation.

Because FOF owns CEFs that trade at a discount, FOF’s discount is a “discount on a discount”.

For example, if the average price of FOF portfolio holdings is $9.00 per share and its associated NAV is $10.00, then FOF’s imputed portfolio discount is 10%. Excluding the management fee for a moment, FOF’s NAV is 9.00 per share—the average share price of its portfolio holdings. If FOF trades at a discount of 10% to its NAV of $9.00 per share ($8.10), then it is trading at a 19% gross discount to the NAV of its portfolio holdings ($10.00). If you assume a management fee of 1% based upon FOF’s NAV of $9.00 per share, then the inherent portfolio discount is closer to 18%.

As noted above, one thing to keep in mind with thinking about the expense ratio and the NAV is the expense ratio is imputed into the posted NAV calculations. So, it is not necessary to assume a further deduction when looking at the calculated NAV per share. But it is appropriate in the previous example.

Here is a link to a report on FOF. Focus on the segment “Per Share Changes to NAV”.
joeeqcome.web.officeli...

I hope this is helpful.

Joe Eqcome

Mar 29 11:04 AM

[GKurinsky:]

This is a great fund Joe, and the concept of a discount on a discount is very good leverage in a recovering market. It has been working well in the CEF recovery based on the discount narrowing of the funds in the portfolio.
What baffles me a bit is that the actual discount on FOF has not only not narrowed, but has widened to over 8% in the midst of a dynamic rally in the entire CEF sector. To me, this seems counter intuitive, Is their something in the structure of the portfolio, or the holdings of poorly performing funds in the portfolio that have perevented fof from narrowing ? Is it something else that I am missing ?
Thanks in advance for any insights you can provide. I am long FOF, very happy, but confused about the stubborn 8% discount .

Jun 01 11:05 PM