As a retiree, I am drawn to Closed End Funds (CEFs) for their income potential. However, in a strong bull market, CEFs can also provide exceptional capital gains. Last year is an excellent example. The S&P 500 had a banner year, gaining more than 30% but many CEFs had even stronger performance. But after being burned in 2008, risk is just as important to me as return. Therefore, I decided to analyze the best performing CEFs of 2013 and assess how much risk you had to assume to obtain the rewards.
Before launching into the analysis, it is important to understand Return of Capital (ROC) in a bull market environment where a fund's assets are appreciating. In a CEF, the cash available for distributions comes from interest, dividends, and realized capital gains. If a fund distributes more than this cash, it is considered return of capital. However, not all ROC is "bad". For example, if fund assets have appreciated but have not been sold, then the Net Assess Value (NAV) has increased by "unrealized capital gains". When it comes time for a distribution, a fund manager may decide not to sell some of his best performing assets because he believes they will appreciate even more. If he had sold the asset, he would have had plenty of cash for the distribution. However, since he decided not to sell, he may have to delve into savings to pay the distribution and this results in a tax event that is called "return of capital". This type of ROC is not destructive. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase. The CEFs that I looked at in this analysis all have increasing NAV so any ROC was non-destructive.
To select funds for my analysis, I used the data available at CEFConnect.com to select the best performing CEFs based on the following criteria:
- Return on NAV for 2013 was greater than 25%
- Return on Price for 2013 was greater than 25%
- The fund had at least a 6 year history so I could review how well it performed during the bear market of 2008.
- The fund was relatively liquid with an average trading volume exceeding 50,000 shares per day
- The fund had a market cap greater than $150M
The following 11 CEFs met all these criteria.
- JH Financial Opportunities (BTO). This CEF seeks moderate income coupled with capital gains by investing in banks, thrift institutions, and related holding companies. It is currently selling at a 5% discount and holds 181 securities, consisting of 82% equities and 10% preferred stock. During 2008, this fund performed relatively well, with the price dropping by "only" 30%. The fund utilized 18% leverage and has an expense ratio of 1.9%, including interest charges. The distribution is 5.1%, which consists primarily of income and non-destructive ROC.
- Gabelli Equity Trust (GAB). This CEF seeks long-term capital gains by investing in equities. It is currently selling at a 9% premium, which is very high compared with its average premium of 3.1%. The fund holds 396 equities selected for their appreciation potential by the fund manager, Mario Gabelli, and his associates. About 81% of the assets are from the North American region with most of the rest from Europe. This fund was hit hard in 2008, with the price dropping over 50%. The fund utilizes 22% leverage and has an expense ratio of 1.5%, including interest charges. The distribution is variable depending on performance but was an impressive 10.4% in 2013, consisting primarily of non-destructive ROC.
- Gabelli Dividend and Income (GDV). This is another Gabelli CEF that is focused more on dividend paying equity. It is only 64% correlated with its big brother GAB. The fund sells at a discount of 8%, which is a little smaller than its average discount of 10%. The fund has 413 holdings, all equities, with most companies (84%) domiciled in the North America and Europe (13%). This fund also took a beating in 2008, losing about 45%. The fund utilizes 21% leverage and has an expense ratio of 1.4%. The distribution is 5%, consisting of income and non-destructive ROC.
- Gabelli Multimedia (GGT). This is another Gabelli CEF that had outstanding performance last year by investing in companies that create and distribute media materials. This fund was also battered in 2008, losing a high 62%. The fund has 233 holdings, with 77% in the United States and 10% in Europe. About 7% of the companies are from Asia and 4% from Latin America. This fund is only 52% correlated with GAB. GGT utilizes 17% leverage and has an expense ratio of 1.6%, including interest charges. The distribution rate in 11.2%, consisting primarily of long-terms gains and non-destructive ROC.
- H&Q Healthcare Investors (HQH). This CEF seeks long-term capital gains by investing in the healthcare sector, including biotech companies. Interestingly, the healthcare sector held up reasonably well in 2008, with HQH losing "only" about 26%. The fund holds 90 securities, with 90% in stocks and 6% in convertible bonds. The fund currently sells near its NAV, which is typical for this fund. The fund does not use leverage and has an expense ratio of 1.2%. The distribution is 7.3% consisting primarily of capital gains.
- H&Q Life Sciences Investors (HQL). This CEF seeks capital gains by investing in companies in the life sciences industry. It has the same manager as its sister fund, HQH, but focuses more on biotechnology. It holds 94 companies, with more emphasis on small-cap companies than HQH. The two funds are about 81% correlated. The portfolio held by HQL is 88% equities and 9% convertible bonds. The fund currently sells at a discount of 6.5% which is much lower than its average discount of 1%. In 2008, this fund also held up well, losing about 28%. The fund does not use leverage and the expense ratio is 1.4%. The distribution is 7.6%, consisting primarily of capital gains.
- Nuveen Core Equity Alpha (JCE). This CEF seeks to provide long-term total return through capital gains with a secondary objective of income. It selects stocks from the S&P 500 using a proprietary mathematical algorithm. In addition, it can write call options on up to 50% of the portfolio. It currently sells for a 2% discount, which is smaller than its average discount of 6%. The fund has 332 equities spread across many sectors. In 2008, the fund performed better than its peers, losing about 34%. The fund does not use leverage and has a relatively low 1% expense ratio. The distribution is 6.4%, consisting primarily of capital gains and non-destructive ROC.
- Nuveen Tax-Advantaged Total Return (JTA). This CEF seeks to provide a high level of after-tax total return consisting of a combination of dividend income and capital gains. Even though JTA is in the same family as JCE, the two funds are only 45% correlated. JTA has 167 holdings and invests about 73% of its assets in dividend stocks and the rest in senior loans and other debt instruments. The fund's price was hit hard in 2008, losing 60%. JTA currently sells for a discount of 6.2%, which is close to its average discount of 6.8%. The fund utilizes 31% leverage and has an expense ratio of 1.4%, including interest payments. The distribution is 7.3%, consisting of income and non-destructive ROC.
- NexPoint Credit Strategies (NHF). This CEF seeks both income and capital appreciation by investing in a combination of equities (37%) and below investment grade senior loans (18%) and bonds (20%). The fund managers have a flexible mandate and can invest in other assets and also hedge its holdings. The fund currently has a portfolio of 206 securities and provides good diversification in that it is only about 25% to 35% correlated with the other CEFs in this analysis. The fund did not fare well in 2008, with the price dropping almost 58%. NHF currently sells at a large discount of more than 15%, which is more than its average discount of 11.5%. The fund utilizes 30% leverage and has a high expense ratio of 3.1%, including interest payments. The distribution is 6%, consisting primarily of income, without any ROC.
- Royce Micro Cap Trust (RMT). This fund seeks long-term growth of capital by investing in companies with a market cap of less than $750M. It is managed by Chuck Royce, who has a disciplined value approach for selecting companies. It has 392 holdings, with 92% domiciled within the United States. In 2008, the price dropped 46%, which was relatively good for a firm investing in micro-cap stocks. The fund utilizes a relatively small amount (11%) of leverage and has an expense ratio of 1.3%, including interest payments. The distribution last year was a huge 31% since it paid a special distribution at the end of the year. More typical distributions are in the 4% to 5% range.
- Royce Value Trust (RVT). This fund seeks long-term capital gains by investing in a broadly diversified portfolio and by using a disciplined value approach. The portfolio manager is Chuck Royce, who has been at the helm since 1986. This fund has 539 holdings, focused on small-cap to micro-cap stocks with a capitalization less than $2.5 billion. RVT is 82% correlated with RMT and had about the same performance as RMT in 2008, dropping in price by 48%. The fund sells at a discount of 13%, which is slightly more than its average discount of 11.7%. The fund utilizes 11% leverage and has an expense ratio of a low 0.7%, including interest payments. The distribution history is variable but in 2013 the fund distributed 5.4%.
For reference I will compare the CEF performance with the S&P 500.
- SPDR S&P 500 (SPY). This cap weighted ETF contains all 500 stocks in the S&P 500. It has and expense ratio of only 0.09% and yields 1.8%.
To assess the selected CEFs, I plotted the annualized rate of price return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each CEF for the year 2013. The Smartfolio 3 program (Smartfolio.com) was used to generate this plot. The data is shown in Figure 1.
Figure 1. 2013: Risk vs. reward for CEFs
As is evident from the figure, there was a large range of returns and volatility values. For example, HQH had a high rate of return but also had a high volatility. Was the increased return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio.
The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to determine if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than the S&P 500. Conversely, if an asset is below the line, the reward-to-risk is worse than the S&P 500.
Some interesting observations are apparent from Figure 1. First off, because of the way they were selected, all the CEFs generated larger returns than the S&P 500. However, when the stock market has an outstanding year like 2013, it is not easy for an actively managed fund to generate comparable returns without taking great risks. Yes, all the CEFs had higher volatility than SPY but most of the funds were close to the "red line", which means that investors were adequately compensated for the extra risk. In particular, all three of the Gabelli CEFs actually beat the SPY on a risk-adjusted basis. And the funds managed by Royce were also superior, with RMT booking the best risk-adjusted return and RVT not that far behind. I believe this is a testament to the fund managers and illustrates that carefully selected CEFs can be an advantageous addition to your portfolio.
NHF was somewhat of a surprise. This fund has a large percentage of senior loans and bonds which would normally dampen performance. The fact that the managers could generate such a large risk-adjusted return is exceptional. The two worst performers on a risk-adjusted basis were BTO and HQL but even these had impressive performance last year.
So you may be thinking that the performance of these CEFs were due to lucky decisions in 2013. How would these CEFs rate if we looked at performance over a longer time period? To asses longer term performance, I re-ran the analysis for a 5 year look-back period (2009 through 2013). The results are shown in Figure 2 and are even more impressive than the 2013 results. Just about all the CEFs (except for RVT and BTO) beat the SPY on a risk-adjusted basis. The only CEF that lagged significantly was BTO. Over 5 years, HQH, HQL, and GGT booked the best risk-adjusted performance. The Gabelli funds once again turned in impressive performance on both an absolute and a risk-adjusted basis.
Figure 2. Risk vs. reward for selected CEFs over 5 year period
No one knows how the market will perform in the future. However, over the past 5 years, carefully selected CEFs have added performance and diversity to a portfolio. During this bullish period, active managers, such as Gabelli and Royce, often outperformed the S&P 500 index on both an absolute and risk-adjusted basis. These CEFs were more volatile than the market so should only be considered by the risk tolerant investor. In particular, good performance in a bull market cannot be extrapolated to a bear market since all these bull market winners were plummeted in 2008. Like most investments, CEFs can offer advantages in some environment but should be watched carefully for signs of trouble as we move into 2014.