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As a mechanical investment rule, buying a group of poorly performing closed-end funds (CEF) at the end of a particular calendar year does not appear to generate significantly greater incremental total return for a subsequent one year calendar holding period versus its larger sample group. A two year holding period seems to generate better results.

A Reasonable Supposition: Most CEFs pay attractive distributions that are generated from equity ownership in industries with positive cash flow from operations or interest income from fix-income investment securities. So, a valued-oriented investment, like a CEF, trading at a significantly lower price might seem to an investor as an attractive entry point.

An Urban Myth: The graph to the right (click to enlarge) compares the average total return of a sample of 106 CEFs that were in continuous operation during the period (1999 to 2009) with the same year’s total return of a group of 10 CEFs that were the worst performing CEFs the previous year.

No Consistent Advantage: With the exception of cyclical stock market upturns, poorly performing CEFs on a total return basis (price change and distribution yield) did not in the subsequent year consistently perform better than the CEF sample’s average for the period sighted. Only 50% of the time did the group of poorly performing CEFs on average do better than the sample’s average the following year; when it occurred it did so randomly.

Extend the Holding Period: Assuming the holding period was an important variable, the holding period was extended to two years from one year.

The results generated a smoothing pattern demonstrating a greater cyclical consistency with poorly performing CEFs being able to recover on a two-year holding period into and after the 2002 trough. This did not appear the case later in the cycle.

Conclusion: There were a couple of “take-aways” from this analysis.

1. The worst performing CEFs were typically a smaller subset of the CEF market segment with the highest betas or greater implicit risk, e.g. world equity funds, special equity funds and high yield funds, or those not paying a dividend (growth stock oriented). The bulk of the CEFs trade in a narrow total return range due to their high distribution “yield cushion” on the downside and generate more consistent returns.

2. The phase of the economic cycle was an important factor in predicting returns. High risk investments typically do well coming off a trough and are likely to be more depressed in terms of their stock valuations. This was true for a one year holding period.

3. Sectors that run into significant problems are likely to need more than a 12 month period to run their course. This is probably why there was more consistent performance for a two year holding period—albeit, more an early cycle phenomenon.

Caveats: The conclusions in this article are based on a comparison of the 10 worst performing CEFs for a calendar period compared to their subsequent total return versus the sample’s averages.

A different size group of worst performers (“5” vs. “10”) could have generated different results. Additionally, a seasoned CEF stock picker could find opportunities by parsing the worst performing CEFs and picking one or two from the group.

Lastly, the mechanical trading rule regarding buying poorly performing CEFs in anticipation of subsequent greater returns may be more effective when applied within a specific fund type with similar characteristics as opposed to the diverse general CEF market segment.

Disclosure: No disclosure

Source: Let CEF Dogs Lie: The Negligible Benefits of Buying Losers