While I'm not vigorously bearish, I'm inclined to think a market slowdown is something to be expected in the near- to mid-term future. As I described in a previous article, I've been looking at defensive income strategies for that scenario. In my previous article I reviewed option-income, closed end funds, which I felt should be appropriate investments given that mindset. My thesis going into that exercise was that option-income funds were more likely to outperform in a flat market (and less likely to suffer out-sized losses in a slightly down market) than, say, leveraged equity funds. I want to continue on that tack here expanding the view to a second category of defensive-equity closed end funds - those that use strategies designed to generate tax-advantaged returns.
The tax-advantaged CEFs are a bit of a mixed bag. They tend to be leveraged, but to a somewhat lesser extent than the more aggressive equity funds. They use various strategies to generate income, primarily investments in dividend-producing common stocks. Some include preferred as a significant fraction of their portfolios.
I've selected 9 funds in this space and analyzed them using the same criteria I used previously. Favorable tax status for the income produced is a high priority. All of the funds here meet that criterion with most income either being taxable at the 15% rate or tax-deferred until the fund is sold, at which time it is taxed as capital gains.
Reasonably high distribution-yield is obviously important, but I'm also looking for total return despite that somewhat pessimistic view of the market's future. With this in mind, I like to find CEFs that are selling at a discount (or premium, perhaps) below their average discount (or premium). I have generated some reasonable gains by taking advantage of what I took to be excessively low discounts that ultimately reverted closer to their means.
Sustainability of income is a third component. There are closed end funds that produce high yields using less desirable methods. Destructive return of capital is one such, so any fund that has a history of destructively returning capital as a device to generate income is eliminated. What I look for is little, if any, negative undistributed net income and a return on NAV in excess of any distributions on NAV. Keep in mind that some funds use return of capital as a tax-deferral strategy, and that return of capital can be more of an accounting quirk than a problem. Option income, as I understand it, is considered return of capital. Capital gains and capital losses can be structured to generate return of capital based on accounting standards. The tax issue here is that ROC income is not subject to taxation as it is received, rather the income is deducted from the basis value of the holding and, ultimately, taxed as capital gains (assuming, of course, that there are capital gains) when the fund is sold. Hold the fund for a year or more and those gains are long term, thus taxed at the 15% rate for most taxpayers - those in the lowest brackets get off with no taxes due, and those in the highest pay 20% under current regulations. In the event that the holding suffers losses and capital gains are less than the return of capital income, the income is not taxed at all.
John Hancock Tax-Advantaged Global Shareholder Yield Fund (NYSE:HTY)
John Hancock Tax-Advantaged Dividend Income Fund (NYSE:HTD)
Gabelli Dividend&Income Trust (NYSE:GDV)
First Trust Dividend and Income Fund (NYSE:FAV)
Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (NYSE:ETO)
Eaton Vance Tax-Advantaged Global Dividend Income Fund (NYSE:ETG)
Eaton Vance Tax-Advantaged Dividend Income Fund (NYSE:EVT)
Nuveen Tax-Advantaged Dividend Growth Fund (NYSE:JTD)
Nuveen Tax-Advantaged Total Return Strategy Fund (NYSE:JTA)
Table 1 below summarizes some key metrics for the funds:
In contrast to the unleveraged option-income funds I discussed earlier, all but one of these funds use leverage. On the other hand, nearly all are currently priced at substantial discounts to NAV and, more relevant in my view, at discounts to their own average discounts.
All are clearly earning their distributions (despite the sometimes substantial amount of return of capital comprising those distributions) which can be seen by comparing the distribution on NAV to the return on NAV and by looking at the UNII column.
These factors are summarized in this chart which plots discount (or premium) in relation to the 52 week average discount against the fraction of return on NAV that comprises the distributed cash. The most attractive values for both will fall in the lower left hand quadrant.
(Data calculated from Table 1 above)
The A List
On the basis of the criteria outlined, ETG and ETO rise to the top and together comprise my A list for the category.
ETG's portfolio comprises about 80% common stock and 15% preferred stock. It is a global fund split about 60/40 USA/International. It is yielding 7.3%. The distribution has been stable since 2009. For the past year about 60% of the distributions have been return of capital; prior to that there was no ROC from the fund. For the past two years ETG has outperformed the category although it did less well in 2011 and 2010.
ETO is also a global fund with essentially no domestic holdings. The portfolio splits about 80% to 20%, common to preferred stock. Distribution yield is 7.4% with no return of capital. Distribution was increased in 2012 and 2013 for a total increase of 28.5%. It has outperformed in 2012 and 2013.
The B List
A second tier comprises JTD, EVT, GDV and JTA. Each could be attractive to a defensive, income investor although perhaps not as attractive as the A List funds.
I initially had JTD in my A List but decided to move it down a notch. Let's call it a B+, shall we? It has a mix of about 75% common and 20% preferred stocks, all from US companies. It yields 7.4% and had a distribution increase of about 4% in 2012. One one hand I like its deep discount. On the other, the fund underperformed the category last year and its return on NAV is the second lowest in the group. The best of the group, but not quite good enough for an A at this time.
EVT's distribution and total returns are somewhat more modest. It could have made the cut for the A List but its 6.5%, distribution yield, while attractive, is among the lowest in the group. The distribution has been steady since 2009. It is a global fund with a portfolio of 85% common and 15% preferred stock.
GDV's distribution at 5.4% is the lowest of the 9 funds. The distribution was increased by 11.1% for the April payment (ex-date April 11). The fund lists equity and debt securities as its investment objectives but the current portfolio comprises 100% common stock of developed market countries. It is not clear to me how debt would qualify as a tax-advantaged investment, so I was a bit surprised to see it listed as an option for the managers, but there is much about taxes that eludes my admittedly meager understanding.
JTA has the second highest 1 year return on NAV of the group (29.3%) and a 6.9% distribution yield. The fund raised its distribution twice in 2013 from $0.22 to $0.24/share. Its discount is close to its 52 week average discount and has been trending toward reduction in recent weeks.
The Rest of the Pack
The two John Hancock funds are interesting and as different from one another as they are from the rest of the group. HTY could easily have fallen into the B List on the basis of its high yield, but I've decided to put it here instead. It is the only fund of the set that is unleveraged. It is the highest yielder by a substantial margin with a 10.1% payout that is reasonably well supported by NAV return. It is the only fund that sells at a premium and above its 52 week average premium, which is not unexpected when one looks at that 10%+ yield. NAV return for the past year was less than 15%.
HTD has the lowest return on NAV at 8.83%. Distribution is 6.4%. Over the recent past the fund has underperformed consistently.
FAV has, in my view, little to recommend it. Yield is strong at 7.3% but total return is modest relative to the others, and it has consistently lagged in most performance measures. Distribution had been decreased 5 times since 2010. Although there was a modest increase ($0.16 from $0.15) for Jan 2014 the payout remains $0.02 below Jan 2013's level.
Clearly, my vote goes to the Eaton Vance offerings: ETG and ETO. Eaton Vance has long been a leader in tax-advantaged investing, so this does not come as a great surprise. Most of the B List group could easily move up a notch as the market re-prices them. I would not be averse to holding any of them at this time, but I would also not be a buyer. The rest of the pack is, in my view, less competitive with the leaders and, with the possible exception of HTY, should be avoided.
Finally, let me be clear that I am an individual investor with no professional expertise in finance or, especially, tax regulations. The views outlined here represent the results of research I've done for my own investment purposes. I hope that they are useful to others, but I would certainly not expect anyone to take my opinions as advice in lieu of one's own due diligence on the topic.
Disclosure: I am long ETG. 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.
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