There are some excellent buying opportunities in equity closed end funds (CEFs) right now. The category was beaten hard following the taper-fear sell-off of a few months ago and has yet to recover. Doug Albo, who needs no introduction to SA readers who follow equity CEFs, has been covering this category in excellent fashion for years. Anyone who wants to learn about it must start by reviewing Doug's articles.
I want to discuss one such fund today: Columbia Seligman Premium Tech (NYSE:STK). STK is an unleveraged technology fund with an inception date of 25 November 2009. Its investment objective is to produce income and capital appreciation through an options strategy in the technology sector.
Data here comes from cefconnect.com (the premiere resource for closed end fund investors) and the company's annual report.
Let's start by summarizing key metrics for the fund.
Total Net Assets
52 week average discount
Note that the fund is selling at a discount well below its average. This has become a fairly common situation among equity CEFs, although there have been some signs recently of reversions to mean discount/premium levels in the category.
The fund pays a managed distribution, something I tend to avoid, but in this case I made an exception. This means that the fund is committed to a fixed dividend payment that you can count on quarter after quarter. In the case of STK, the fund has paid a $0.4625 quarterly since inception. That's 11.87% on NAV and 12.84% on Market Price. Surely yields like that must be coming at some great cost, right?
Start at the point of greatest controversy: The past 5 quarterly $0.4625 payouts have been 100% Return on Capital. Some will find that shockingly dangerous and immediately answer the question posed in the previous paragraph with a resounding "Yes." They will point out - erroneously I submit - that the fund managers are merely paying your own money back to you. Some will embellish that error with the tidbit "and they're charging you to do so." But it is not correct for this option-income fund. Nor for many other high-ROC option income funds that face this charge. Those who follow this category know that has been discussed and debated here seemingly endlessly. Doug Albo has summed up the ROC situation for a tax-advantaged, option-income equity CEF quite well. I refer the reader to this article and the last couple of sections of this article for his observations. In fact, if you're new to CEFs, review as much of Doug's contributions as you can. It will be time well spent.
Suffice it to say here that ROC is not the evil some portray it as. When a fund has returns on NAV in excess of its distributions on NAV it is not returning your money at the expense of the fund's asset value. That's simple arithmetic. And such is the case for STK. Here's the twelve-month annualized data:
Distribution Rate on NAV…
Total Return on NAV…
Then there is another seemingly too-good-to-be-true element here. ROC is, from the IRS's point of view, not taxable income. That's right. The nearly 13% STK is paying: It's like the proceeds from a municipal bond fund in terms of the taxes you would have had to pay for the last 5 quarters' income. Tell me, where else are you going to get 13% and not pay the IRS a dime?
Ok, I hear you. It is not tax-free income such as one would get from a muni bond fund; that's an exaggeration. But it is tax-deferred. The tax treatment for ROC, as I understand it, is that distributions are not taxed; they are deducted from the investment's basis. Thus, if and when the holding is sold, those distributions are taxed as long- or short-term capital gains. (I am emphatically not a CPA nor a tax advisor of any kind, and I've been wrong on things before, so be sure to check this with a knowledgeable tax advisor.)
I'm speculating here, but I would not be surprised to see a November distribution that returns some taxable capital gains directly and knocks back that ROC component. Also, tax laws are always in flux. The ROC advantage could disappear at any time. And, with all the talk of raising revenues by "closing loopholes" rather than raising tax rates, it's not hard to see this "loophole" as being at risk. It's a fairly easy one to take away too as it doesn't have nearly the broad constituency that, oh let's say, muni bonds or dividend stocks have.
One final point in anticipation of the other major objection that comes from CEF naysayers every time CEFs are discussed: Negative UNII (Undistributed Net Investment Income). Although excessively high negative UNII can signal dangerously threatened distribution sustainability, option-income funds commonly have modest levels of negative UNII. For STK it is currently -$0.0329, a mere 7% of the quarterly distribution. I submit to the naysayers that this does not even begin to approach a worrisome UNII, although I'm sure someone will bring it up anyway.
How has STK performed other than on a distribution yield basis? Here's where the cautious investor will want to pay close attention. Last year (2012) was not a good one for STK. Its market price underperformed its category by about 75% as its NAV was essentially flat for the year. This year has been a very different story on the NAV front where YTD returns are nearly precisely tracking the category gains of about 11%, but market price - perhaps reflecting last year's hangover - has lagged the category by about 40%. On the surface that 40% may sound terrible, but to a buyer it's a gift, opening as it does a huge discount on purchase and the prospects for a reduction of that discount if the managers can continue at their current pace.
Going further back, 2011 was also a rough year for STK, but in 2010 it performed admirably. Past performance may not be indicative of future returns, but it does give us a clue to the managers' abilities to deliver. From the results, there is real potential for stress on this front. On the other hand, the fund has paid its managed distribution every quarter without a hitch.
Summing up here: STK is an attractive opportunity for the income investor looking to pump up portfolio yield. It is paying just shy of 13% in part due to the market having mispriced it relative to its Net Asset Value and recent performance. I would not expect this mispricing to last, so the interested investor will want to explore that interest without delay.
Would I bet the house on it? Not at all. But a small, speculative stake? I'm in.
Sound a bit too outré for you? Take a look at some of the other option-income CEFs. Start with Doug Albo's contributions, keeping in mind that the space is always changing. Go to cefconnect.com and screen for tax-advantaged and covered-call equities, US and global. Some places to start: Eaton Vance has some steady winners like ETV and ETW, paying >10%, BlackRock's BOE pays almost 9%, plus there's a host more. Mind you, I'm not recommending any of these, just suggesting what might be in store for an interested reader.
Finally, if you think I've got this wrong, I really would like to hear from you.
As always, I remind readers that I am an individual investor. I have no claims to professional expertise of any sort in stock evaluation or tax affairs. I'm just sharing some research in the hope that it may be useful for others. Any actions a reader may want to take based on this research must necessarily be based on his or her own careful due diligence and with full consideration of his or her individual goals and needs.
Disclosure: I am long STK. 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.