One of the first articles I wrote on Seeking Alpha back on January 6, 2011, was titled, "Income Strategies For All Market Seasons" and I believe it was the first article written by any author which discussed the basic income strategies that equity based high yielding Closed-End funds (CEFs) use to generate the income they pass on to investors in the form of high distributions and yields. You can read the article here, Strategies for Market Seasons.
I've come a long ways since then in terms of quality of my articles but I believe the premise of the original article needs repeating, since it highlights one of the strongest reasons why equity CEFs can be so advantageous for investors.
In the article, I pointed out that there were three basic income strategies that equity CEFs used to derive income. There was the (1). leveraged strategy, the (2). option-income strategy and the (3). dividend-harvest strategy. Some funds even used a combination of these strategies. However, for purposes of this article, I'm going to disregard the dividend harvest strategy since only a few funds use this as their primary income strategy and as I have pointed out many times in past articles, the dividend harvest strategy really doesn't work.
So let's concentrate on the first two strategies ... the leveraged strategy and the option-income strategy. Here is why these two strategies are so useful for investors. Their greatest appeal is that they each excel in different market environments, or market seasons. Not only can they excel, they can solidly outperform their benchmarks when their income strategy is optimized. The leveraged strategy excels in a strong up market and the option-income strategy excels in a flat to up and down market in which no clear trend is established. The option-income strategy will also outperform in a down market though it is not necessarily immune to a bear market even if it outperforms its benchmarks. Of course, each fund has a unique portfolio of securities and varying risk attributes based on the amount of leverage used or the level of options used so this will result in varying degrees of outperformance.
So why is this advantageous to investors? Because knowing which strategy excels in which market environment allows you to adjust your portfolio to the market "seasons" whether you want to define seasons on a calendar basis or some other basis. For example, on a calendar basis, you may feel that the 4th and 1st quarters are often the strongest so you might want to overweight the leveraged funds during this period. Or on a valuation basis, you might feel that the market is overbought and vulnerable to a correction period but you still want to receive income from your equity investments. In such a situation, you might want to overweight the option-income funds.
To show you what I'm talking about, here are the leveraged (orange) and option-income (light blue) fund tables sorted by their total return Net Asset Value (NAV) performances since January 1, 2012, through March 15, 2013, or a little over 15 months. Funds which have outperformed the S&P 500, as represented by the SPDR S&P 500 Trust (NYSEARCA:SPY), are shown in green and funds whose NAVs have underperformed are shown in red.
Leveraged CEF's: Sorted By Total Return NAV Performance
Option-Income CEF's: Sorted By Total Return NAV Performance
As you can see, it's been difficult for most funds to outperform the S&P 500, up 27.2% since January 1, 2012, including dividends, 24.1% without. Some of that is due to the portfolio makeup of these funds, which may include international stocks, sector specific stocks and/or fixed-income securities though much of it, I believe, is due to the massive amounts of liquidity which goes straight into the major market ETFs like SPY, making it difficult for any fund manager, whether it be a CEF, mutual fund or even the vast majority of ETFs, to outperform the S&P 500. Virtually none of the option-income funds have been able to outperform the S&P 500 and only about half of the leveraged funds have been able to outperform. But if the markets ever stalled or went through a correction period, that's when you would start to see the option-income funds start to catch up. Note: Only about 2/3 of the option-income funds were able to be included in this table.
Market Price vs. NAV Price
You'll notice in the tables that there are two columns of total return performances. One is based on the NAV price of the fund and the other is based on the market price. Though one might expect the market price to mirror the direction of a fund's NAV price, this is not always the case and you'll see that even though most fund's market prices have performed better than their NAV prices since January 1, 2012, some have not. This is shown in the % Difference Between NAV/Mkt column which reflects the difference between a fund's NAV performance and its market price performance. In fact, many option-income funds are actually outperforming the S&P 500 on their market price even while their NAV's are underperforming. Generally speaking however, when I say a fund can "excel" or "outperform" in a certain market environment, I'm really referring to the fund's NAV.
As most investors know, a CEF's NAV is its true value and represents all of the portfolio assets minus all liabilities. Unlike the "book value" of a stock, the NAV of a CEF is actually about what you would receive if the fund ever liquidated, matured or merged with another fund. So the NAV is really your financial interest in the fund as long as you don't have to sell it. Anybody who believes that the "book value" of a company is what you would receive if you owned the public stock of a company that had to liquidate should probably stop right here and invest in stocks instead.
For equity CEFs however, most of which invest in liquid large cap stocks of US and overseas based companies, you can pretty much rely on the NAV of the fund as its liquidation value if anything went wrong (not necessarily the case for fixed-income bond CEFs however). This is a big reason why I stick with equity CEFs and am somewhat less confident in pure fixed-income CEFs, most of which use heavy amounts of leverage. By the way, there are many equity CEFs that include up to 50% fixed income securities in their portfolios such as preferred securities, convertible securities, corporate bonds, etc. so there are plenty of choices for investors among equity based CEFs. I just happen to classify any CEF with portfolios 50% or higher in stocks as equity based.
This variation of styles and portfolios among equity CEFs is another reason why I like them because they won't all necessarily rise or fall together. One thing you'll notice among fixed income CEFs is that they all tend to move as a group. The sell-off in muni bonds last week was a good example of that. Now here I am talking about the market price though generally speaking, I don't pay a lot of attention to the day-to-day market price moves of equity CEFs since they can often make little sense. Yes, the market price is what you buy and sell the fund at and yes, it also gives you your actual distribution yield you receive. However, the market price of a CEF is only important in regards to the discount or premium to the fund's NAV, which establishes the fund's over or undervaluation. In other words, since the market price of a fund is subject to the emotions and sentiment of investors, I give it very little credibility since investors in these funds are often wrong.
On the other hand, the fund's NAV is subject only to the performance of its underlying holdings and as long as you don't have to sell the fund prematurely, that is a much more important valuation to keep track of. CEFs are the only investment I know of that gives you a definitive valuation of what the investment is worth and yet investors are able to speculate on whether the fund is worth more or less than that value. Of course, this assumes investors know what the NAV of the fund is or know what market environment it excels in. As we'll see however, most investors are pretty clueless when it comes to knowing much more than the market price and market yield of a fund.
Why CEF Investors Are Often Wrong
We all need advantages in the markets to make money and equity CEFs give you one of the biggest of all. It's a fact that most investors in equity CEFs pay very little attention to the NAV and many don't even know about it. Many just assume that the fund is actually a high yielding ETF that has no other basis for valuation other than its market price. So they will either look at the fund's market yield (a certain money losing strategy), technical support/resistance levels (really inapplicable to a CEF) or the fund's reputation for distribution consistency or whether it is from a well-respected fund sponsor or not. All of these, however, mean nothing compared to the fund's NAV or more accurately, the fund's NAV performance taking into account all distributions. Following a fund's NAV will tell you more about the health and well-being of the fund than any other factor. Following a fund's NAV, taking into account all distributions, is the primary reason why I have been able to call 25+ distribution cuts and raises since I started writing on Seeking Alpha in early 2011.
Following a fund's NAV and knowing which fund strategy excels in which market environment can give you a huge advantage over other investors over time. Let me tell you some of the more common mistakes investors make in these funds.
- The first is buying funds with the highest yields. This is a sure way to lose money since many of the funds with the highest yields are often eroding their NAVs to pay for it and most of these funds ultimately have very poor total return performances, even when you add back those high distributions. What's interesting is that many of these funds will often trade at premiums since their high yields continue to attract investors even while their NAVs deteriorate.
- Second, when a correction begins in the markets, it's usually the most defensive option-income funds that sell off first. This is totally counter-intuitive but it's a fact. The reason is because investors will want to hold onto their better performing leveraged funds during an up market period and will sell their laggard option-income funds at the first sign of a market correction.
- Third, investors will often push up the market price of a fund before it goes ex-dividend and the fund will often sell off afterwards. These are often good times to add or reduce your holdings.
- Fourth, investors assume that if a fund cuts its distribution then something is wrong with the fund and it should be sold. Actually, when a CEF cuts its distribution, this may be the best time to buy. That's because the fund may not have been able to sustain and grow its NAV before the cut, but may be in a much better position afterwards. Often, the fund will fall in market price so that you receive a yield that is not much different than before the cut anyway.
- Fifth, investors assume that the fund is responsible for paying the market price yield. Wrong...the fund is responsible for paying the NAV yield. It's investors who establish the market price yield. If an investor buys a fund at a premium market price, they are actually receiving less of a yield than the fund is actually paying, whereas investors who buy a fund at a discount, pick up a windfall yield over and above what the fund is actually paying.
- Sixth, investors assume that funds at the widest discounts are there for a reason and have either inferior management or subpar performances, whereas funds at premiums have either better management and/or are performing better. This is probably the biggest fallacy in equity CEFs. In fact, I would say that it is often the best funds that trade at the widest discounts and often the worst that will trade at premiums (like the highest yielding funds mentioned above).
What I would like to do next is discuss a few individual funds and investment ideas taking into account some of the observations noted above. Due to the length of this article, I will be back with some actionable ideas for investors.
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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.