In July of last year, I wrote an article on how to construct a high income, lower risk portfolio using Closed End Funds (CEFs). Since the article was written, the S&P 500 has continued to propel upward in a phenomenal bull market. This article takes a fresh look at the portfolio that I recommended and assesses if the risks-versus-rewards profile has significantly changed. The portfolio is primarily focused on equities although there are some allocations to bonds within a few of the funds. The CEFs in the portfolio satisfy the following criteria:
- I wanted to analyze CEFs over a complete bear and bull market cycle, so I chose CEFs that had a history going back to 12 October 2007 (the start of the 2008 bear market).
- The CEFs had to be liquid, with an average trading volume of at least 50,000 shares per day.
- The distribution had to be at least 6%.
- The Market Capitalization had to be at least $100 million.
- Return of Capital (ROC), if any, had to be non-destructive.
Return of Capital is an important concept when investing in Closed End Funds and deserves some additional discussion. One of the key things to realize that the definition of ROC is not the common sense definition but is instead based on accounting rules. For a CEF, the cash available for distribution comes from interest, dividends, and realized capital gains made in the current period. If a fund distributes more than this cash, it is labeled as return of capital by the accountants.
However, not all ROC is considered "bad". For example, if fund assets have appreciated but have not been sold, then the Net Asset Value (NAV) has increased by what is called "unrealized capital gains". When it comes time for a distribution, the 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 not enough "immediate" cash flow to pay the distribution. He therefore has to delve into savings, which results in an accounting event that is termed "return of capital". This type of ROC is not destructive. This non-destructive ROC often happens in a bull market when equity holdings are appreciating.
To summarize, ROC is considered "good" or constructive if the ROC comes from pass-through events like unrealized capital gains. ROC is bad or destructive when investors literally receive back their own capital as part of the distribution. Sometimes it is difficult to determine if ROC is good or bad. My rule of thumb is that ROC is not destructive as long as the NAV continues to increase.
The portfolio reviewed last July consisted of the following CEFs:
Dow 30 Enhanced Premium & Income (DPO): This CEF sells at a 2% discount which is higher than the 52 week average discount of 4.4%. The fund invests in a portfolio of the 30 stocks that make up the Dow Jones Industrial Average but also attempts to enhance performance by using a covered call strategy. The distribution is 6.3% with a substantial non-destructive ROC. The fund utilizes 25% leverage to increase returns and has an expense ratio of 1%. Since July of last year, the price of DPO has had some ups and downs but it has now appreciated to a new high for the year.
Gabelli Equity Trust (NYSE:GAB): This CEF sells at a premium of 3.9% which is a little below the average premium of 4.9%. This fund utilizes a strict value methodology and has been managed by the founder, Mario Gabelli, since its inception in 1986. Mr. Gabelli also owns, directly or indirectly, about 1.6 million shares of the fund. The fund has 404 holdings, with about 82% invested in North America and the rest primarily in Europe. It uses 20% leverage and has an expense ratio of 1.4%. The distribution rate is 8%, which has a small ROC component. The ROC is not surprising or destructive since most of the ROC comes from unrealized capital gains. Since July of last year, GAB has trended higher but the current price is about 5% below the peak made in March.
Clough Global Equity (NYSEMKT:GLQ): This CEF sells at a 11% discount, which is slightly less than its average discount of 11.6%. The managers of this fund have a flexible mandate and can invest worldwide in equities, corporate bonds, and sovereign debt. It can also use an option strategy to increase income. Currently, the fund holds 180 securities with 71% invested in U.S companies and the rest invested primarily in cash alternatives. The fund employs 45% leverage and has a relatively high expense ratio of 3.3%. The distribution rate is 8.3% with only a small amount of ROC. The price of GLQ is about the same as it was in last July.
H&Q Healthcare Investor (NYSE:HQH): Over the past year, the price of this CEF has oscillated between a 4% premium and a 4% discount. Currently the fund is selling at a 2.4% discount. It has 85 holdings focused on healthcare, including biotechnology, medical devices, and pharmaceuticals. It does not use leverage but many of holdings are smaller, emerging companies. It has an expense ratio of 1.3% and the distribution rate is 8% with no ROC (the recent distributions have been funded by long and short term gains). The price of HQH has trended higher since last July but the current price is 17% below the high made in February due primarily to a selloff in the biotech sector. Another reasons for the price decline is that HQH will potentially increase the number of shares by 33% with a rights offering in June of this year. Once the offering was announced, the premium evaporated and the price began to contract even though the Net Asset Value has been recovering. More insight on the offering can be found in a recent Seeking Alpha article by Left Banker.
Nuveen Core Equity Alpha (NYSE:JCE): This CEF sells at a discount of 1%, which is less than the average discount of 5.6%. It has 322 holdings selected from the S&P 500 by using a proprietary mathematical algorithm. The formula attempts to add "alpha" by generating returns better than the S&P 500. It does not employ leverage and has a 1% expense ratio. It has a distribution of 6.1%, consisting primarily of non-destructive ROC and long term gains. The price of JCE has continued to increase since I reported on it in July and it is now near a 52-week high. Limit orders should be used when buying and selling this CEF because the volume is not high (just barely meeting my threshold of 50,000 shares per day).
Kayne Anderson MLP (NYSE:KYN): This fund sells at small premium of 0.2%, which is substantially below its average premium of 7.2%. This fund has 66 holdings, all of which are Master Limited Partnerships (NYSEARCA:MLPS). It employs 30% leverage and has a 2.6% expense ratio. The distribution rate is 6.5%, which is paid from income and non-destructive ROC The NAV of KYN has been in an uptrend since last July but the price has not appreciated greatly (resulting in a loss of premium).
LMP Capital & Income (NYSE:SCD): This CEF sells at a 10.5% discount, which is lower than the average discount of 9.9%. It has 101 holdings, spread primarily among general equity (82%) and convertible bonds (17%). It employs 20% leverage and has a 1.4% expense ratio. The distribution rate is 6.6%, which is paid from income and non-destructive ROC. The price of SCD has trended higher since last July and is near the high for the year.
Assuming equal weight, these CEFs average a little over 7% annual distributions so they definitely satisfy my desire for high income. To assess the risk-adjusted return since last July (about 10 months), I used the Smartfolio 3 program (www.smartfolio.com). Figure 1 provides the rate of return (called Excess Mu on the charts) in excess of the risk free rate. This rate of return is plotted against the historical volatility over the period of the analysis. For reference, I have also plotted the risk-adjusted return associated with the SPDR S&P 500 ETF (NYSEARCA:SPY).
Figure 1. Risk vs. Reward since 1 July 2013
As is evident from the figure, the CEFs had a wide range of returns and volatilities. HQH had the highest return but also had the largest volatility. Was the increased return worth the increased risk? To answer this question, I calculated the Sharpe Ratio for each fund.
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 assess 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 SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY.
Over the period since last July, the overall portfolio return has been good but not quite as good as the S&P 500. This is not too surprising since SPY has been in a rip roaring bull market making it difficult for actively managed funds to keep pace. With the exception of HQH, all the other funds had similar volatilities in the 10% to 15% range, which is historically very low. Unfortunately (for my portfolio) all the CEFs were either on or below the "red line". Thus the risk-adjusted return of SPY was better than that associated with my recommended CEF portfolio.
Among the CEFs, JCE had the best risk adjusted return, followed by DPO and GAB. The risk-adjusted return of HQH was similar to that of GLQ. The return associated with KYN was very low resulting in a poor risk-adjusted performance. I generally like MLPs and KYN has been an excellent performer in the past but in February of 2014, KYN issued new stock, which was not greeted well by investors. The NAV of KYN has continued to increase but the stock price sold offer causing the premium to morph into a discount. This resulted in poor price performance over the period of interest.
To summarize, the recommended CEF portfolio has performed good but not great over the near term. However, to show how the portfolio has performed over the long term, I expanded the look-back period to 12 October, 2007, the beginning of the 2008 horrendous bear market. The results are shown in Figure 2.
Figure 2. Risk versus reward since 10/12/2007
What a difference a few years made! The CEF portfolio delivered a significantly better return than the S&P 500 and this was achieved with a slightly smaller volatility. Thus, the CEF portfolio substantially outperformed the stock market on a risk adjusted basis. In fact, every one of the CEFs in the portfolio either equaled or outperformed SPY.
Among the CEFs, HQH booked the best performance, leaving the other CEFs in the dust. The next best CEFs were JCE and KYN, with roughly the same risk-adjusted performance. None of the CEFs performed badly but GLQ lagged by a slight amount. During this period, KYN and GAB had the highest volatilities but their increased returns adequately compensated for the increased risks. Note also that the combined portfolio had a volatility that was less than the constituent volatilities. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize.
The CEF portfolio has held its own since being recommended last year. However, the portfolio really shines over the long term that includes both bull and bear cycles. No one knows how this portfolio will perform going forward but based on past performance it is worthy of consideration by investors seeking high income at a reasonable risk.
Disclosure: I am long DPO, GAB, HQH, JCE, KYN, SCD, GLQ. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.