Large Cap CEFs Underperform Large Cap ETF, Offer Other Advantages

Closed-end funds (CEFs) that invest in large cap stocks have materially underperformed the Russell 1000 (Large Cap) Index over the past stock market cycle as measured by the ETF iShares Russell 1000 Index Fund (IWB). Additionally, the sector portfolio holdings of the three CEFs that invest in large cap stocks don’t appear materially different than that of the large cap ETF (IWB). (See table below).

Case Closed: This is a logical conclusion given the advantages of a large cap ETF like IWB over a CEF. Such advantages include: size and portfolio diversification; low expense ratio (0.15% versus average 1.5% for CEFs); no managed distribution policy, i.e., IWB doesn’t typically make return of capital distributions; market liquidity. For investors looking to participate long-term in large cap stocks, case closed!

click to enlarge

But Wait: There is one CEF metric that might make two of the three large cap CEFs an interesting trade. This is the materially wide current discount spread to their respective average year-end historical discounts. Currently, Blue Chip Value Fund (BLU) and Zweig Fund (ZF) are trading at a discount spread of -15.3% and -18.7%, respectively. If the stocks gravitated to their average historically discount, the share price would appreciate 18.8% and 23.7%, respectively. (During the early phase of a stock market recovery, CEFs discounts have a tendency to contract.)

Faux Distributions: Both CEFs pay a distribution yield around 12%. Both BLU and ZF employ managed distribution policies that are based upon 10% of year-end NAV.

This means they are making significant return-of-capital distributions in difficult stock market environments. This reduces NAVs.

Low Entry Point: Given the CEFs’ low cost per share, it provides an easy entry point for large cap investors willing to assume a modicum of risk. This is a short-term 3-to-6 month trading idea. If the trade fails to materialize, it’s like falling out a 2nd story window and breaking your leg, as oppose to a 20 story window and crushing your head.

Disclosure: Author owns BLU, TY and ZF.

Comments

[jse17:]

Spot on Joe and do not forget one of your favorites, ADX! ADX spikes the punch with its holding of PEO, a CEF managed by the ADX team!

The total management fee for the combined holding is approximately 1% with a resulting combined discount of in general terms of 25%- 30% and occasionally greater.

Hmmmm!

Apr 08 07:58 PM

[Alan Young:]

Is your chart a price chart or a TOTAL RETURN chart? Those 12% annual distributions would make a huge difference!
So, please be clear.
The discount can be helpful at times but is incidental to your point about performance. Total return is the key.

Apr 09 10:00 AM

[Joe Eqcome:]

Alan Young

Your points are thoughtful. The chart accompanying the article was based on monthly share price change and not total return.

To your point, I do have a chart comparing the annual total returns of large cap CEFs with the S&P 500. It shows the same pattern although a much less pronounced. Indexed at year-end 2001, CEFs underperformed the S&P 500 by 19% by the end of 2008 on a total return basis.

I also agree that total return is the right metric for evaluating long term investments. Since my observation regarding both BLU and ZF were for short-term trading purposes (3 to 6 months) the distribution was less important.

Joe Eqcome



On Apr 09 10:00 AM Alan Young wrote:

> Is your chart a price chart or a TOTAL RETURN chart? Those 12% annual
> distributions would make a huge difference!
> So, please be clear.
> The discount can be helpful at times but is incidental to your point
> about performance. Total return is the key.
>

Apr 09 12:38 PM