Summary: The most important measurement for the effectiveness of a CEF fund advisor is “value-add”: the amount of relative incremental investment value generated as a result of its stewardship of its fund’s investments. This is particularly important in this day-and-age where there is a plethora of low cost, easily-assessable, indexed, investment alternatives such as ETFs.
Eqcome CEF Value-Added Management Rankings: In an effort to determine which of the CEF’s managements were adding the most value for their shareholders, a sample of 160 CEFs were processed through the Eqcome CEF Value-Added Management Rankings model (Eqcome CEF “VAMR”).
Keep It Simple Stupid (KISS): The simple assumption is how much NAV total return is a CEF investment advisor generating per 100 basis points (1.0%) of management fees weighted by its return variability. Beyond that, by imputing a weighted premium or discount to this ranking an investor is able to derive the relative long-term attractiveness of a particular CEF stock investment.
Value-Added Management Ranking (VAMR) Assumptions:
1. The point of departure for this model is the average annual NAV total return over the CEF’s operating history. This would include the annual change in NAV plus the NAV distribution yield.
2. The average NAV total return was divided by the most recent basic expense ratio of the CEF to calculate the NAV total return per 100 basis points of management fee (“TRtrnNAVFee”).
3. The TRtrnNAVFee was then weighted by the variability of such a return in an attempt to neutralize the volatility of the asset class being invested.
4. This “ValAddMgmtRtrnNAV” is a calculation of return per unit cost of management (100 basis points). The higher the value the more value an investor is receiving from its CEF management.
Why Use NAV Total Return? The NAV total return was employed as it represents monies directly invested with the manager and represents the total return results of its efforts. The NAV total return is not influenced by the price variability of the stock which is based on market forces outside the control of the investment manager.
Winners and Losers: A sample 160 CEFs (600 CEF universe) with at least a 5 year operating history were engaged for this analysis. The chart below illustrates both the “Top 5” (green) and the “Bottom 5” CEFs (blue) based on VAMR NAV total return.
Results: The average NAV total return for the Top 5 rankings for ValAddMgmtRtrnNAV was not that far apart (9.4% versus 7.2%, respectively). However, there was a stark difference in the “Value-Add” per fees paid relative to assets invested.
At each end of the “barbell” both management fees and the standard deviation of NAV total returns played a meaningful role. The Top 5 was aided by a low expense ratio (0.49%) and lower historical return volatility (0.13); the opposite was true for the Bottom 5 CEFs: 1.17% and 0.51, respectively. So, not only did the Top 5 generate a higher nominally NAV total return, but they generated higher management investment productivity adjusted for fees and return volatility.
While there was little correlation between the average NAV total return and management fees (R^2=.037), there was a middling correlation between management fees and the ranking of CEFs by NAV VAMR (R^= 46.7%). (Click Here for list of rankings.)
Fees Do Matter: While a low expense ratio provides an advantage in generating higher after-fee returns for its investors, management must also deliver suitable investment returns.
Value Added CEF Stocks: The VAMR for NAV total return was weighted based upon a stock’s premium or discount relative to the sample to obtain the relative long-term attractiveness of these stocks. The Top 5 CEFs where management generated attractive returns per expense ratios both on an NAV and market value (stock) basis were: Adams Express (ADX) and Petroleum & Resources (PEO). Both CEFs are self-administered by a similar management team and have very low basic management fees.
Less Good: Four stocks that occupied the Bottom 5 were similar with regards to their NAV and stock VAMRs. Two of the stocks were “busted plays”: Managed High Yield Plus (HYF) and DWS RREEF Real Estate II (SRO). BlackRock Dividend Achievers (BDV) was anything but; it generated pathetic NAV total return performance. All three support the sub-optimal management thesis being advanced.
The one exception to the poor investment management rule for the Bottom 5 was Turkish Investment Fund (TKF). Actually, TKF has generated an attractive average NAV total return, trades at a modest discount and charges a reasonable fee. Unfortunately, its annual return is highly volatile. This has negatively impacted its stock VAMR.
The last of the Bottom 5’s stock VAMR is Gabelli Utility Trust (GUT). On its fundamentals GUT is at best a mediocre performer (ranks 109 out of 160 on its ValAddNAVMgmtRtrn). However, the fact that it is trading at the highest premium of all CEFs made it one of the worse CEF stock values. (See Article entitled: “Why GUT's Rights Offerings is Better for the Advisor Than Shareholders” (1/13/10).
Caveats: Eqcome CEF VAMR(s) is one tool for looking at the productivity of a CEF’s management. It should be employed along with other fundamental and technical investment tools. VAMR favors large CEFs over smaller ones and those with low return volatility. It is likely a more valuable tool for long-term CEF investors based on the model’s constructs.
Parting Comments: While a pilgrim in the land of CEFs, I’ve come to realize early in this journey that some CEF investors operate in the Bermuda Triangle of investing; or worse, in Superman’s Bizarro World.
Some CEF investors appear to do the opposite of what normal investors do here on Earth. They appear to chase return-of-capital distributions that have no investment value and purchase stocks at prices substantially greater than their intrinsic value (premium to NAV) in order to do so. This investment approach is at best gambling; at its worst, it represents financial instruments of personal destruction.
Disclosure: diversified holdings of CEFs including positions in ADX, PEO, NXR, TY, GAM; no position in GUT