As I promised in my February 4th article, The Most Under And Overvalued Funds, I was going to come back 6 months later and see how my undervalued and overvalued high yielding equity based closed-end funds (CEFs) picks had performed. I don't know how many contributors would hand pick funds (not stocks) with no knowledge of how the next six months would unfold for the markets and yet feel pretty confident that their undervalued picks would outperform their overvalued picks, but that's what I did.
These funds were selected by a two step process which screened virtually all of the equity CEFs available to income investors. The first step looked at which fund's Net Asset Values (NAVs) had outperformed or at least kept up with the S&P 500 since January 1, 2012, whereas the second step further screened the funds in terms of which fund's NAVs had also either outperformed or underperformed their market prices the most. I further narrowed each group taking into consideration other variables such as their premium/discount level, NAV and market yields, etc. but really, the first two steps established the primary screening process.
The theory here is that funds with strong NAV performances which had not seen their market prices keep up would probably be in line to outperform in the future whereas funds which had underperforming NAVs since January 1, 2012, but yet had seen their market prices outpace their NAVs for one reason or another, usually due to their excessively high yields, would probably be in line to underperform. It should also be noted that funds which have underperforming NAVs and outperforming market prices are often the ones at premium valuations, thus adding another red flag to the fund's outlook.
The point I wanted to prove in this exercise was to make investors realize what they should be looking for when selecting income oriented CEFs. Most investors will only look at factors that are derived from the fund's market price since obviously that is what investors buy and sell the funds at and that is what investors receive their yield on. However, basing your decisions on a fund's market price and market yield, i.e. the higher the better, is a certain strategy to underperform because it ignores the one criteria that the investor should really be focused on...the NAV of the fund. I would liken this comparison to the famous quote from Benjamin Graham, considered the father of value investing, when he wrote...
"In the short term, the stock market behaves like a voting machine, but in the long term it acts like a weighing machine (i.e. its true value will in the long run be reflected in its stock price)."
In other words, think of a CEF's market price as the voting machine and a fund's NAV as its weighing machine. For a CEF, its market price is subject to the whims and emotions of investors whereas a CEF's NAV is only subject to the performance of its holdings. So why would you give any credibility to the emotions of investors when you have the final say as to the true value of the fund with its NAV? Time and time again, I have shown that if you want to find the best CEFs to invest in, forget about the market price and forget about the market yield. Follow a fund's NAV total return performance, which includes all its distributions along the way, and you will find the best performing funds at the market price over time as well.
In my analysis above, that's all I did. I didn't even have to know how the fund's portfolio of stocks or bonds were going to perform over the next 6 months and as it turned out, some of my picks included portfolios which had most of their holdings in underperforming sectors such as utilities or fixed-income securities. But that didn't really matter that much when you looked at the funds as a group. The fact that these funds had historically outperformed at the NAV level and yet their market prices were not reflecting that superior longer term trend meant that they were more likely to catch up and outperform. This is something you can only see if you follow the fund's NAV.
So how did my picks perform over the last 6 months? If you go to my article from February 4th (link above) you'll see the 12 funds which made my undervalued list and the 8 funds which made my overvalued list. In the table below, I compare those same funds by their total return market price performances in the highlighted vertical box (including 6-months of distributions). Note: funds are color coded by their income strategy, orange for a leveraged strategy and light blue for an option-income strategy.
For comparison purposes, the S&P 500 was up 12.5% over the same period. However, for most of these equity based CEFs, income would be listed as their primary investment objective and their strategies are not necessarily designed to match the performance of the major stock market indices such as the S&P 500. In addition, many of these funds also have international stocks in their portfolios, which have generally underperformed the US markets.
Couple things to notice about these numbers. First, the high yields of the overvalued funds didn't help their total return performances at all. Something to think about when judging funds by their yield. And second, except for a few instances, the discounts/premiums did not change that much over the past 6 months. In the world of CEFs, 6 months is still considered a short term "voting machine" mentality.
But this gives income investors an opportunity since I have found that the best funds with the best historical NAV total returns will eventually return to their outperformance even if their portfolios or income strategy is currently out of favor. One such fund I believe reflects this right now is the John Hancock Tax-Advantaged Dividend Income fund (HTD).
HTD is a 33% leveraged fund (on total assets managed) offering a very conservative 6.3% market yield (5.6% NAV yield) paid monthly. HTD's portfolio is 50% mostly US based stocks in the financial and utility sectors and 48% in preferred securities as of 6/30/2013. That may sound like a fairly stodgy portfolio but HTD's NAV performance over the years has been nothing short of stellar due to leverage and superior fund management.
I want to show you HTD's total return NAV performance compared to the S&P 500, as represented by the SPDR S&P 500 Trust (SPY), over two time frames. One is from close to the market highs at the end of the 3rd quarter 2007 and the other is from close to the market lows at the end of the 1st quarter 2009. I like to use these two longer term time frames (over 3-years and 5-years) because it shows the actual fund performance during bear and bull market environments and too often I've seen funds that perform great in one market environment but not the other. The first table shows quarter end valuations of HTD and SPY from 9/30/2007 with their running distributions (dividends) added back to give you a running total return performance. Green represents up quarters for the market and red represents down quarters.
And here is the same table from close to the market lows at the end of the 1st quarter '09 (3/31/2009).
I have not found any equity CEF whose NAV has outperformed the S&P 500 by this wide of margin over these two time frames. Even Morningstar has HTD as a 4-star, silver rated fund, which makes me wonder who they give a 5-star fund to if not HTD.
Now I suppose one could argue that with interest rates rising, this changes the complexion of CEFs which have large percentages of fixed-income securities (such as preferred securities) in their portfolios and certainly, HTD has not had as good of NAV or market price performance YTD in 2013 as in the past, up 10.1% YTD on its NAV and only 8.5% on its market price as of August 5th. Yet this is where management can play a key role since the fund's only mandate is to invest at least 80% of the fund's assets in dividend-paying common and preferred securities which qualify for favorable tax treatment.
Of the three main sectors the fund currently invests in - financial stocks, utility stocks and preferreds - only the financial sector has outperformed in 2013 but the fund managers, both of whom have been with the fund since inception, have quite a bit of leeway to adjust the portfolio weightings to a changing market environment. In addition, The fund can also sell index options against the stock portion of the portfolio for added income.
What I find interesting about the John Hancock CEFs is that they have two equity based funds, the John Hancock Tax-Advantaged Global Shareholder Yield fund (HTY) and the John Hancock Financial Opportunities fund (BTO), that can trade at premium valuations and yet the best performing fund of all of them trades at a -10.6% discount.
How much better has HTD been over the years? Here is the market price performance of HTD (red), HTY (blue), BTO (green) and SPY (pink) from around the market bottom at the end of the 1st quarter 2009. Total return in this graph, provided by Stock Charts, includes all distributions on a re-invested basis.
Now here is the graph over the past year which shows HTD now lagging HTY, BTO and SPY pretty significantly.
With HTD currently out of favor and trading at a relatively wide -10.6% discount, I believe this is an opportunity for income and growth investors to step up to a fund which has proven its reliability to adapt to a changing market environment over the years. CEFs may go in and out of favor based on their portfolios and income strategies, but only rarely will you find a fund that can weather most any market environment and because of that HTD makes for an excellent long term hold. HTD's current market price is $18.68 and the fund goes ex-dividend at a 6.3% yield on August 8th.
Additional disclosure: Short SPY