For those who follow the Closed-End fund (CEF) universe, this last year has shown how much the industry has matured despite the fact that CEFs overall, did not have nearly as positive a year as their Exchange Traded fund (ETF) cousins. Generally, CEFs fall somewhere in between individual stocks and ETFs in terms of risk but because of their lower market capitalizations (usually $250 million to $1 billion) and lower trading volumes, they can often trade at bizarre valuations and with extreme volatility at times. Offsetting that is their higher yields of 6% to 9% that investors can receive and the fact that they can trade at premium and discount market prices to their actual net worth, commonly called the Net Asset Value (NAV).
This latter feature is unique to CEFs and offers investors a built-in valuation metric that no other investment class offers. Though many investors like to compare a CEF's NAV to a stock's book value, they are hardly comparable. Try relying on a company's book value if a company ever went bankrupt and you will probably be waiting a long time to recoup your stock losses. In stock based CEFs, however, a fund's NAV is about what you would get if a fund liquidated, and yet CEFs often trade at market prices wildly different than their NAVs, sometimes at discounts of -15% or more.
During the financial crisis of 2008, CEF discounts dropped to -25% or more for short periods even though in a worst case scenario, if a fund sponsor announced the liquidation of a fund during this bear market period, investors in the fund would have seen the market price rise to reflect the NAV liquidation value virtually over-night, give or take a slight time and market volatility discount.
Will Discounts And Premiums Always Be A Way Of Life For CEFs?
Why is this? Why do some CEFs trade at premiums when most others trade at wide discounts no matter how strong their NAV is performing? Knowing that a fund's NAV is its liquidation value, why would a CEF's market price ever stray that far from its NAV? I've been following CEFs for years and a fund's valuation, as determined by its market price discount or premium, will often have nothing to do with the fundamentals of the CEF, exactly the opposite of stocks. In stocks, if a company is growing and its products are hitting the markets at the right time, it is usually rewarded with a higher valuation. Not necessarily so in CEFs. Often it is the best performing funds at the NAV level that trade at the widest market price discounts and the worst that trade at lofty premiums.
Indeed, what determines valuations in CEFs can be quite arbitrary but generally, a fund's valuation is based first and foremost by its yield, where the higher the yield, the higher the valuation. It was often as simple as that. Find the funds with 12%+ yields and they generally traded at the highest valuations even though these funds were often the ones eroding their NAVs the most with destructive Return of Capital (ROC) in their distributions. Though I pointed this out many times in articles I wrote here on Seeking Alpha from 2011 to today, often it didn't matter. Investors would still base their investment decisions on which funds had the highest yields or in some cases, which funds came from the most popular fund sponsors. It wasn't until a fund was forced to cut its distribution, something that I called over and over again over the past few years - about 40 times in fact - that a fund finally started to reflect its true valuation.
So could it be that investors think that CEFs are only good for their high yields and even then, you take a risk that the fund will eventually cut its distribution and go down in price anyway? Perhaps this does account for the general malaise in CEFs and their perpetual discounted market prices.
In 2011 for example, which was a flat year for the S&P 500 and a down year for the NASDAQ, I recommended investors overweight the most defensive option-income funds, like the Eaton Vance Tax-Managed Buy/Write Income fund (NYSE:ETB), the Eaton Vance Tax-Managed Buy/Write Opportunities fund (NYSE:ETV) and the even more defensive Nuveen option-income funds such as the Nuveen Equity Premium Opportunity fund (NYSE:JSN), the Nuveen Equity Premium Advantage fund (NYSE:JLA) and the Nuveen Equity Premium Income fund (NYSE:JPZ), and yet the funds still got crushed on their market prices even though their NAVs were up on the year 5% to 6% on a total return basis.
So despite the fact that their benchmark S&P 500 and NASDAQ-100 indices were flat to down that year and the fund's defensive income strategies were perfectly positioned to take advantage of that, all of these fund's market prices still got walloped. ETB ended 2011 at a -12.6% discount, ETV ended at a -14% discount, JSN at a -11.6% discount, JLA at a -13.3% discount and JPZ at a -13.3% discount. This should not have happened but because many option-income funds had also begun to reduce their distributions in early 2011 to get their NAV yields more in line with their income, investors never even considered their NAV outperformances that year.
On the hand, investors in CEFs can grossly misprice CEFs to the upside too. For years, equity funds from the Alpine and Cornerstone family of funds traded at unheard of premiums of up to 40%, 50%, 75% to even 100%, even though these funds were ticking time bombs destined to eventually collapse due to their unsustainable yields and/or ineffective income strategies. Even the PIMCO family of CEFs, which tend to trade at some of the highest premiums of all CEFs currently, have at least started to reflect some measure of reasonableness in their premium prices. This is not to say that some funds, like the PIMCO Global Stocksplus & Income fund (NYSE:PGP), won't continue to trade at an astronomical premium valuation, currently 55.5%, but at least we can say that the trend is finally starting to catch up to the over-priced funds and is starting to help the under-priced funds.
Will CEFs Finally Be Valued By Their NAV Performances?
This trend towards more rational CEF valuations, based on NAV total return performance and not simply by yield, is something I have been expecting for some time and was really the inspiration of writing articles on Seeking Alpha in the first place.
Contrary to popular belief, CEFs don't have to be considered just income investments and can outperform their more popular and heavily traded ETF cousins. Though the primary objective of most CEFs is income first, appreciation second, this does not mean CEFs can't outperform the broader markets. In 2012, we saw that happen as many equity CEFs I follow handily outperformed the S&P 500, up 13.4% (15.9% with dividends). This is shown in the following table of equity based CEFs sorted by their total return market prices in 2012. NOTE: Only roughly 30 of about 100 equity CEFs I follow can be shown.
2013 - Party Time For ETFs, Not So Much For CEFs
In 2013, this trend towards CEFs finally moving to more appropriate valuations continued. I don't know if this is because individual investors are becoming more educated on CEFs or if more institutional investors are warming up to CEFs because of their valuations, but I hope this trend continues despite the fact that many equity CEFs still trade at what I would consider undervalued levels.
Overall, equity CEFs had a good year in 2013, unlike pure fixed-income CEFs which were generally down on the year. Certainly, equity CEFs which focused on utilities, commodities, REITs and gold did not have a good 2013, as you might expect, but a few pure leveraged stock funds from Gabelli GAMCO Investors (NYSE:GBL) and a couple healthcare focused funds from Tekla Capital (former Hambrecht & Quist) handily outperformed the broader markets.
Taken as a whole however, only about 15 equity based CEFs were able to outperform the S&P 500 in 2013, which was up 29.6% for the year (32% with dividends added back). Here is the same table from above showing the top 30 or sorted by their total return market price performances for 2013. Again, only the top 30 or so funds are shown out of about 100.
Comparing the 2013 table with the 2012 table above and you can see what a difference a year makes. There are, of course, several reasons for this. The first is a rise in interest rates last year which tends to put a damper on yield oriented securities like CEFs. A second reason - which is really a result of the first reason - is that the income strategies of most CEFs were not as optimized in 2013. For example, many funds that used a defensive option-income strategy were not able to capture near the amount of upside of a ramp-up market that never seemed to pull back much. Nor did many funds which used a leveraged income strategy because most leveraged CEFs include fixed-income securities in their portfolios such as preferred securities, corporate high yield bonds and/or convertible securities. Then consider that many equity CEFs also include international stocks which generally underperformed US stocks and it should not be unexpected that CEFs would mostly underperform the broad market and sector ETFs that enjoyed 30%+ returns in 2013.
However, the biggest reason in my mind why equity based ETFs ran away from equity based CEFs had less to do with interest rates and more to do with the Federal Reserve's Quantitative Easing (QE) program.
2013 - The Year Of The NAV
For investors who may not be aware, ETFs and mutual funds also trade based on their NAVs, though ETF's can at times, trade at slight discounts and premiums like CEFs but usually not by much and certainly nothing close to CEFs.
But there's a big difference between how ETFs and CEFs are structured and how they trade in the primary and secondary markets. The biggest and most liquid ETFs, like from the SPDR family of funds (State Street Global Advisors) or from iShares (BlackRock) for example, can trade tens of millions of shares per day. But trying to match ETF market prices with the aggregate value of their component stocks is not easy and so there are what are called authorized participants, which are large broker-dealers such as banks, brokers, specialists and market makers which deal directly with the ETF in the primary market to exchange much larger blocks of shares of the fund called creation units.
Creation units represent the NAV of the ETF and are baskets of underlying securities which make up the ETF. So during the course of a business day, the ETF itself is not buying or selling its component stocks on the secondary market since this would be very hard for the fund sponsor to do while it is being bought and sold in real time. Instead, it's up to the authorized participants to be buying and selling the component stocks and exchanging in large block creation units with the ETF so that the actual NAV and the market price of the ETF don't differentiate by that much.
So what happens when investors (individual and institutional) are buying ETFs is that an ETF's market price might get ahead of its component stocks, in which case, the authorized participants may go out and buy the relatively undervalued component stocks so that they can exchange in creation units the relatively higher priced ETF. These market balancing forces are how ETF market prices pretty much reflect their NAVs at all times and if you want to read more on this subject, you can check out this link here.
However, for CEFs, there is no such connection between the fund's market price and its NAV and so a CEF's market price is purely a function of supply and demand on the open secondary market whereas its NAV is purely a function of the value of its component stocks and securities. CEFs are mostly owned by individual investors seeking income so unless there is larger buy interest, say from an institutional investor, nothing is forced on a CEF's market price to move it up even if its NAV moves up.
So think about who this benefits in a year like 2013, where the Federal Reserve's Quantitative Easing program was providing a pipeline of liquidity to institutional firms like banks and brokers each and every month. If you're a big institution with excess cash and want to put it to work, what is the easiest and most liquid way for you to get broad stock market exposure? ETFs ... particularly the biggest and most liquid ETFs.
In fact, you could argue that some ETFs, like the very popular and heavily traded small cap ETF iShares Russell 2000 (NYSEARCA:IWM), could actually influence the price of its component stocks, resulting in a tail-wagging-the-dog affect. If you were an institutional investor flush with cash and wanted more exposure in small cap stocks, would you rather own a much more liquid ETF like IWM trading about 35 million shares a day or its less liquid component stocks? It's really a no-brainer. Certainly, the aggregate market cap of the Russell 2000 stocks is much larger than the aggregate market cap of ETFs that invest in them. But here, we are talking about the volume of shares traded and for small cap stocks which don't trade nearly as many shares as larger cap stocks, a heavily traded ETF like IWM could actually drive up the price of its component stocks.
Is this a microcosm of what happened in 2013? Certainly, no one argues that the Fed's QE was a boon to stocks and funds overall but the dynamics of how QE benefited certain market sectors and securities more than others will be important to note as the Fed withdraws its QE program.
What To Expect In 2014
As I write this, the markets have once again, stopped any downside momentum from gathering steam and have turned it around for the umpteenth time to set new 52-week highs to even all-time highs for many of the major US market indices. It's become almost surreal how our markets can seem to go one direction and one direction only even as the Federal Reserve begins to wind down its QE program.
History may not repeat itself, but if in fact it does rhyme, then 2014 could shape up to be a year like 2000 in my opinion. If you remember the year 2000, the markets initially soared after the Y2K worries turned out to be a big nothing and the technology sector was enjoying a run like no other fueled by the nascent computer industry at the time. By the end of the 1st qtr 2000, the NASDAQ was at an all-time high 5000 and the markets seemed like they could do no wrong. I even remember some institutional money managers closing shop because they were short technology and had finally just thrown in the towel.
Of course, what most investors forget back in 2000 is that NASDAQ stocks were priced in fractions and not decimals so a bid/ask may have had a 1/2 point ($0.50) spread to even a 1 point ($1.00) spread or more back in 2000. Compare that to the penny spreads ($0.01) you see today between the bid/ask and you realize that back in 2000 it was a lot easier to move a NASDAQ stock up or down than it is today. In other words, high liquidity and volume has become a much more important factor today in moving markets and anything that impacts that will have an exaggerated effect on the markets.
Now you can argue that many technology companies that had gone public around the turn of the century had no earnings and it was all a big bubble as the internet and cell phone revolution had yet to even get started. However, I could argue today that the latest runup in technology and small cap stocks is really being driven by excess liquidity provided by the Federal Reserve's QE program and that the direction of the markets will now be more dependent on the Federal Reserve than the growth fundamentals of the technology sector.
As Good As It Gets?
So to borrow a line from Jack Nicholson from the movie of the same name, "What if this is as good as it gets?"
Now, I have no crystal ball and I try and manage portfolios to be able to take advantage of the markets no matter which way they go, but I'm concerned about what impact the Fed's tapering of its bond buying program will ultimately have on the confidence of this market going higher from here. Yes, the first announcement by the Fed on December 18th started a market rally that carried until the end of the year but what about the third or fourth tapering? Will the reaction still be so positive once everyone realizes that the markets will not have the Fed's liquidity spigot to rely on and the markets will have to stand more and more on their own finally? What will happen when the mindset of investors goes from, "Where can I make the most money?" to "How can I hold onto the money that I have made?"
Due to the length of this article, I will come back with a second article discussing the outlook for CEFs vs. ETFs in 2014 as well as which CEFs may be in line to outperform.