Exploiting CEF Market Sector Inefficiency with FOF

Closed end fund (CEF) investors do not appear to price into their stock valuations an implied option premium or payment for potential capital gains or losses in the underlying investment portfolio that may materially impact investment returns. CEF investors appear to make their investment decision based on a fairly consistent initial benchmark yield based on net investment income.

Implications: During a directional change in a CEF’s underlying assets (NAV), traders can capture capital gains pricing inefficiently being appropriately long or short the stock. Cohen & Steers Closed-End Opportunity Fund (FOF) may currently be a way to play this inefficiency. (See “Recommendation:” section below for details)

Summary: Net investment income and capital gains (realized and unrealized) are the primary components of investment return for CEF investors. While it is difficult to project annual capital gains for a CEF, it is much easier to focus on the predictable net investment income. Through the process of elimination investors can do a better job of analyzing the role of capital gains in the CEF valuations process.

Methodology: I aggregated the operating performance numbers provided in the “Financial Highlights” of annual and semi-annual reports for CEFs comprising the Eqcome CEFBig10™ to analyze net investment income. (The CEFBig10™ consists of 10 CEF stocks each representing one of the largest within each of the 10 major CEF fund types. It is designed to represent a diversified CEF investment portfolio and act as a proxy for this market segment.)

Observations: The chart below illustrates in summary the aggregate operating performance of the CEFBig10™. Of particularly interest was the consistency of return on net investment income (“ROEInvInc”) in line “A” below. Based upon the beginning year’s NAV, the ROEInvInc has consistently hovered around 6%. This has been true in up-markets and down-markets and consistent with respect to the annualized data for the five CEFs that have reported semi-annually to-date.

The ability of investors to price CEFs based upon an initial yield expectation of 6% in our analysis is not a function of their investment skills but a function of the consistency of the net investment income. For aggregate fiscal years from 2005 to 2008, the net investment income per share averaged $.90 per share within a tight range of $.87 to $.96.

It appears from the data that CEF investors are seeking an attractive distribution level (CD investors looking for high dividend income) and appear less focused on the variability of the CEF’s NAV or stock price.

On line “F” on the chart above, the implied stock price was calculated based upon a 6.3% initial benchmark yield (marked-up for the discount of the stock price to NAV) on actual net investment income for that year. It was compared to the actual share price at the beginning of each respective year. The difference between the two was nominal (line “G”).

Seeking Rational Investors: One would have predicted that a rational investor would pay the equivalent of a option premium, i.e., pay more for the stock than the implied stock price at a 6% yield, for the potential of capital gains; or, receive an option payment, i.e., pay less than the implied stock price, if investors believed capital gains were to decline.

Incremental Returns: Beyond the net investment income, there are annual returns that are generated from real and unrealized capital gains: capital gains distributions and share price appreciation based upon the underlying change in NAV. Line “L” is the total non net investment income by source with line “O” being expressed as a percentage of beginning year’s share price.

Recommendation: I believe the CEF market sector is in the process of a robust recovery from a severe cyclical decline that was made harsher by the disruption of the auction rate preferred securities (ARPs) market which was heavily employed by CEFs.

Since the CEFBig10™ can’t be purchased as a unit to take advantage of the CEF market sector’s potential recovery and this capital gain pricing inefficiency, I would recommend Cohen & Steers Closed-End Opportunity Fund (FOF) for that role with a few caveats.

FOF is a CEF that invests in other CEFs. It doesn’t employ leverage, its current expense ratio (0.95%) is below industry average, it’s trading at near its widest discount of almost 7% (remember the actual effective discount is greater because the CEF stocks FOF is buying are also trading at a discount—a discount on a discount) and the sponsor has credibility in the equity income space.

What I don’t like about the stock is that it is paying a current annualized distribution greater than its annual net investment income for calendar year ‘08: $1.08 versus $.74 per share, respectively. The balance of the distribution was a return of capital.

Let’s do the numbers: Assuming that investors are willing to pay 6.3% on net investment income (actual average initial benchmark yield for FOF is closer to 5%), FOF stock should be trading an implied valuation of $11.75 per share. I would expect the dividend to be reduced to a rate closer to net investment income at some future point in time.

Let’s assume it resets its distribution to an annualized rate of $.70 per share; therefore, at its current price of $10.30, the imputed yield on the reduced dividend would be 6.8%. Effectively, an investor is being paid for taking a risk on potential capital gains.

Of course, at the point of any potential declaration of a dividend reduction, the stock price would likely experience a “knee jerk” sell-off as investors who purchased it for yield would dump it in dismay. That would be the time to load up.

One strategy would be to split your purchases into two 50% baskets: 1) purchase the stock on regular installments over the next couple of weeks/months—particularly on any weakness; 2) purchase the remaining 50% of your position after any announcement of a dividend reduction. This strategy may not be everyone’s or anyone’s cup of tea.

Disclosure: I own FOF and other CEF securities.

Comments

[Alan Young:]

Wow--impressive analysis. I never would have guessed that yields would be so consistent in the CEF world!

"Assuming that investors are willing to pay 6.3% on net investment income" ... That is not clear to me.
Do you mean, "investors are willing to pay a share price that implies a 6.3% yield"?

My other concern about this analysis: have you compared the asset class allocation within FOF to your idealized 10 equal-weighted categories? They could be quite different, for all I know...

thanks Joe

Jul 18 11:29 PM

[Joe Eqcome:]

Alan Young

The more I reflect on the results of the analysis, the more it seems to makes sense. Most CEF investors seem willing to pay for recurring earnings—as the main objective is a high, current, recurring distribution; they are less willing to pay for capital gains—because of their inability to predict them—and nothing for return of capital distributions.

For the sake of illustration, let’s assume that a CEF had net investment income of $1.20 per share, capital gains of $.25 and distributes $.15 as a return of capital. Based upon a consistent implied threshold earnings yield requirement of 6% for our sample, the implied valuation per share would be 20.00 (1.20/.06) at the beginning of the year based on recurring earning (net investment income). This would translate into price/earnings (P/E) multiple of 16.7 times recurring earnings (the reciprocal of the earnings yield 1/.06).

Let’s assume that the distribution is 1.60 per share based upon the combination of net investment income, capital gains and return of capital (1.20+.25+.15= 1.60). Based upon the implied share price of 20 per share, the yield would be 8.0%. While an attractive yield, it may not be sustainable; thereby, forcing investors to rely on recurring income as a basis of valuation.

So, the tentative conclusion is that investors may be basing their valuation on recurring net income and apply a fairly consistent threshold earnings yield criterion, while ignoring capital gains and return of capital distributions—or at the very least discounting them heavily. This may in turn create an opportunity to capture this capital gains pricing inefficiency.

You are correct regarding the composition of the CEFBig10 and FOF; their portfolio compositions are different. However FOF’s top industry’s break out appears to have an “OK” distribution among the various fund types. (FOF’s average earnings yield appears to be closer to 5% versus 6% for the CEFBig10.)

I like to spend some more time exploring whether valuation is based on a multiple of net investment income.

Joe Eqcome



On Jul 18 11:29 PM Alan Young wrote:

> Wow--impressive analysis. I never would have guessed that yields
> would be so consistent in the CEF world!
>
> "Assuming that investors are willing to pay 6.3% on net investment
> income" ... That is not clear to me.
> Do you mean, "investors are willing to pay a share price that implies
> a 6.3% yield"?
>
> My other concern about this analysis: have you compared the asset
> class allocation within FOF to your idealized 10 equal-weighted categories?
> They could be quite different, for all I know...
>
> thanks Joe

Jul 20 12:26 PM

[Greg Spears:]

Mr. Joe,
Would you please explain to me in very simple terms the following:

1. What is Return of Capital? Over time does this reduce the NAV?

2. In doing an "Advanced Search" on CEFA i am sorting the funds by "Income Only". Would you explain to me what it means if the Income Only Yield is greater than the Dist Yield?
I realize this are basic questions for many but I am new CEF and need some help.
I enjoy your blogs very much. They are great help to a rookie like me.
Thanks

Jul 21 11:05 AM

[Joe Eqcome:]

Greg

I am happy to respond to your inquiry and encourage your exploration of this market segment as I believe it is under-researched and more likely to yield positive relative performance.

A return of capital is just as it sounds. You are getting back the capital that you’ve invested; it doesn’t represent a return “on” your investment, but a return “of” your investment.

For example, let’s say you give your uncle 1,000 to invest. As oppose to investing it in some form of assets, he puts it under his mattress. At the end of the year he sends you a distribution of $100. This is considered a return of your capital: you’re getting back your own money. The value of your investment is now $900. So, in fact a return of capital does reduce your NAV.

The difference between your uncle and Bernie Madoff is whether he tells you it’s a return of capital distribution.

If you click on the “Yield Def” above the actual yields on the individual reports in the CEFA site, it will provide a detailed definition of the two.

Essentially, “Income Only Yield” is a calculation based on net investment income, after dividends to preferred shares, divided by the average NAV.

The “Distribution Yield” is the cash dividend, which may include net investment income, capital gains and return of capital, divided by share price.

The comparisons of the two are useless as each represents vastly different numerators.

I’d encourage you to go to the www.SEC.gov and look up the CEF and go to the “Financial Highlights” to get a better feeling for the relationship among these numbers.

Joe Eqcome



On Jul 21 11:05 AM Greg Spears wrote:

> Mr. Joe,
> Would you please explain to me in very simple terms the following:
>
>
> 1. What is Return of Capital? Over time does this reduce the NAV?
>
>
> 2. In doing an "Advanced Search" on CEFA i am sorting the funds by
> "Income Only". Would you explain to me what it means if the Income
> Only Yield is greater than the Dist Yield?
> I realize this are basic questions for many but I am new CEF and
> need some help.
> I enjoy your blogs very much. They are great help to a rookie like
> me.
> Thanks

Jul 21 12:21 PM

[Greg Spears:]

Mr. Joe,
Thank you for your response. I did go to Sec.gov but could not find Financial Highlights?

Is there any relationship to be made between "Inc Only Yield" and a funds ability to maintain there Dist Yield? Meaning, if the Inc Yield is 7% and the Dist Yield is 6%, would it be a logical assumption that company had a better chance of maintaining the Dividend than a fund that had a 6% Inc Yield and a 7% Dist Yield?

I have accumulated sevral CEF in my portfolio. I now feel the need to add some "Fixed Income" I am having a hard time getting anyone (Muni Bond Brokers) to explain to me why I should buy individual muni boands over Muni CEF's? Would you please shae some insight with me and shre with some Muni CEF's? I understand any funds you provide would not be recommendations.
Sincerely,
Greg

Jul 22 09:31 AM

[Sapphire:]

Hi Joe,

I looked at FOF, but opted instead to diversify into about 20 closed-end funds that I chose myself. I notice that the funds I picked are also within FOF's portfolio. However, I think I got them at better discounts and therefore a much better overall yield than FOF has been paying, particularly considering the heavily discounted prices many popular CEF's were selling at earlier this year. Others who do not wish to do this much research, monitoring, and juggling may find FOF a fairly safe alternative way to diversify into a number of CEF's, however.

One concern I had is since FOF charges a management fee, as do all the CEF's in its lineup, could not the discount - which is small at this point - be negated by a "fees on top of fees" issue?

Jul 25 11:29 PM

[Joe Eqcome:]

Greg

I’m sorry on the SEC.gov suggestion that I was not clearer. Here is an algorithm that might be helpful.

Go to etfconnect.com. For this example put in the symbol “NCV” and it will take you to an NCV report. In the right hand column under “Third Party Links & Reports” click “SEC” Filings”. It will take you to the SEC filings on NCV. Under the “Form column click on “N-CSR” “html” which will take you to another page. Then once again on “N-CSR” and it will take you to the annual report. Scroll down to page 27 and those would be the financial highlights. You’ll be able to determine the composition of earnings and importantly the composition of the distribution “Dividends and Distributions to Common Shareholders”.

“Income Only Yield” and “Distribution Yield” are not comparable because the numerators are different and would not be useful in determining the safety of the distribution.

What you might consider is taking the “income only yield” which represents the net investment income divided by the average net asset value and multiple it by the ratio of NAV divided by the share price.

The following example may make the point. A CEF has $.90 in net investment income (nii), $.10 capital gains and $.05 in return of capital for a total distribution of $1.05. The stock price is $10 and the NAV is $12 for a discount of 16.7%

The “income only yield” would be $.90/12, or 7.5%. The net income divided by the NAV. The distribution yield would be the total distribution divided by the stock price: 1.05/10, or 10.5%. As you see the calculations aren’t comparable.

However, if you wanted to get a feel for the safety of the dividend, you would take the “income only yield” and multiple it by the ratio of NAV over the stock price: .075 X (12/10) = 9.0%. This would tell you of the 10.5% Distribution yield, only 9.0% is supported by net investment income which is typically more recurring. This calculation isn’t perfect, but it’s a good approximation.

There are two categories of munis: national and single state. For the purpose of being conservative I pick national munis for diversification purposes and ones with little to no leverage. I would look into BTA and MHF. Both are selling at respectable yields and trading at a slight discount.

I hope this is helpful

Joe Eqcome



On Jul 22 09:31 AM Greg Spears wrote:

> Mr. Joe,
> Thank you for your response. I did go to Sec.gov but could not find
> Financial Highlights?
>
> Is there any relationship to be made between "Inc Only Yield" and
> a funds ability to maintain there Dist Yield? Meaning, if the Inc
> Yield is 7% and the Dist Yield is 6%, would it be a logical assumption
> that company had a better chance of maintaining the Dividend than
> a fund that had a 6% Inc Yield and a 7% Dist Yield?
>
> I have accumulated sevral CEF in my portfolio. I now feel the need
> to add some "Fixed Income" I am having a hard time getting anyone
> (Muni Bond Brokers) to explain to me why I should buy individual
> muni boands over Muni CEF's? Would you please shae some insight with
> me and shre with some Muni CEF's? I understand any funds you provide
> would not be recommendations.
> Sincerely,
> Greg

Jul 26 08:27 PM

[Joe Eqcome:]

Sapphire

I applaud the fact that you did your own research and pick out a portfolio with which you are comfortable. Kudos!

To the extent that FOF is trading at a 3.7% discount and FOF’s management fee is around 1%, you’d have approximately a four year payback period. So, if you wanted to own the shares for less than 4 years it might be appropriate.

The other issue is the cost of trading. When you buy FOF, depending on the amount, you will usually pay a single commission fee. For most on-line brokers is less than $10. If you buy 20 individual stocks you’ll be paying the equivalent of $200 for the portfolio. So, this is a cost to be considered.

For someone like yourself, doing the research and picking your own stocks is great way to learn about the CEFs and empowers you to learn more.

I hope this is helpful.

Joe Eqcome

Jul 26 08:45 PM

[Joe Eqcome:]

Greg

I’m sorry on the SEC.gov suggestion that I was not clearer. Here is an algorithm that might be helpful.

Go to etfconnect.com. For this example put in the symbol “NCV” and it will take you to an NCV report. In the right hand column under “Third Party Links & Reports” click “SEC” Filings”. It will take you to the SEC filings on NCV. Under the “Form column click on “N-CSR” “html” which will take you to another page. Then once again on “N-CSR” and it will take you to the annual report. Scroll down to page 27 and those would be the financial highlights. You’ll be able to determine the composition of earnings and importantly the composition of the distribution “Dividends and Distributions to Common Shareholders”.

“Income Only Yield” and “Distribution Yield” are not comparable because the numerators are different and would not be useful in determining the safety of the distribution.

What you might consider is taking the “income only yield” which represents the net investment income divided by the average net asset value and multiple it by the ratio of NAV divided by the share price.

The following example may make the point. A CEF has $.90 in net investment income (nii), $.10 capital gains and $.05 in return of capital for a total distribution of $1.05. The stock price is $10 and the NAV is $12 for a discount of 16.7%

The “income only yield” would be $.90/12, or 7.5%. The net income divided by the NAV. The distribution yield would be the total distribution divided by the stock price: 1.05/10, or 10.5%. As you see the calculations aren’t comparable.

However, if you wanted to get a feel for the safety of the dividend, you would take the “income only yield” and multiple it by the ratio of NAV over the stock price: .075 X (12/10) = 9.0%. This would tell you of the 10.5% Distribution yield, only 9.0% is supported by net investment income which is typically more recurring. This calculation isn’t perfect, but it’s a good approximation.

There are two categories of munis: national and single state. For the purpose of being conservative I pick national munis for diversification purposes and ones with little to no leverage. I would look into BTA and MHF. Both are selling at respectable yields and trading at a slight discount.

I hope this is helpful

Joe Eqcome

Jul 26 08:47 PM

[Sapphire:]

Joe - thanks for your reply. I do like the funds and their allocation in FOF; in fact, I sometimes look at the individual holdings in FOF and compare them to mine to evaluate my own choices. My impression, after researching many closed end funds myself, is that FOF's manager is a good one who knows his stuff.

I have really enjoyed learning more about closed end funds and choosing my own, as I find it a very interesting asset class. But for those who don't have the time or inclination to do this, I think FOF is a good vehicle with less downside risk than many individual closed-end funds out there. It will be interesting to see how it performs long-term.

Thanks for the article -

Sapphire

On Jul 26 08:45 PM Joe Eqcome wrote:

> Sapphire
>
> I applaud the fact that you did your own research and pick out a
> portfolio with which you are comfortable. Kudos!
>
> To the extent that FOF is trading at a 3.7% discount and FOF’s management
> fee is around 1%, you’d have approximately a four year payback period.
> So, if you wanted to own the shares for less than 4 years it might
> be appropriate.
>
> The other issue is the cost of trading. When you buy FOF, depending
> on the amount, you will usually pay a single commission fee. For
> most on-line brokers is less than $10. If you buy 20 individual stocks
> you’ll be paying the equivalent of $200 for the portfolio. So, this
> is a cost to be considered.
>
> For someone like yourself, doing the research and picking your own
> stocks is great way to learn about the CEFs and empowers you to learn
> more.
>
> I hope this is helpful.
>
> Joe Eqcome

Jul 26 10:49 PM