- What's next once you learn how to tell if a CEF is 1. a good value, 2. has a sustainable dividend and 3. the manager is performing well?.
- How many CEFs in a portfolio give the ability for alpha, but avoid being too concentrated?.
- When does relative value swapping of a CEF (even a munis) make sense on an after tax basis?.
What is the next level of closed-end fund analysis? This article expands on some of our previous work, including, "The Closed-End Fund Trifecta" and "CEF Discounts: A Master Class in Nuance". Both are available on our blog. Followers of our firm will know we advocate answering three questions in selecting a closed-end fund, calling this our CEF Trifecta:
- Is a CEF priced at a relative value to itself and peers?
- Is the dividend level sustainable? and;
- Is the manager or sector performing well on a net asset value (NAV) basis?
What is missing from this perspective? We find that some investors seem to lack a plan in designing and maintaining their portfolio and we believe adding the following concepts to our Trifecta analysis will improve your long-term investment performance.
Step 1: Portfolio Construction and Management: First, we always recommend investors decide on an asset allocation that meets their unique goals and risk tolerance, and to document what they expect to achieve from an investments before starting the strategy. This might sound basic, but we find it is often overlooked. We find a lot of comfort in cutting a loss early or taking a gain when there are more attractive or better performing funds available to swap into while maintaining a similar investment strategy.
A prime example of this is when building a municipal bond CEF portfolio; we generally see two typical investor psyches. One group of investors are driven by tax-equivalent-yields (TEY); they are tax-sensitive and primarily looking for investment grade Bond exposure of 10% or more TEY, depending on their marginal tax bracket. They want to maintain a stable or growing amount of tax-free income and expect the "principal" of the account to be secure over time. However, they understand there will likely be positive and negative years for the account's principal value and that in general the discounts of Municipal Bonds, and other CEFs, move in cyclical trends.
We find a second group of investors tend to be generally more conservative and less tax-sensitive. They are looking for lower-risk total return and are driven to Municipal Bonds due to their favorable credit spreads, low history of defaults and, their historically "boring" nature. Over the past year, the average Muni CEF had a 6.3 NAV Standard Deviation, about 4 if you back out leverage, and a Market Price Standard Deviation more than double NAV at 13.2. Some people take this volatility as a risk, but we think of it as an opportunity to make better entry and exit trades. As long as you monitor current and historical trends you can take advantage of this phenomenon.
It needs to be noted this extra volatility vs. direct bond or traditional open-end fund ownership is due to Leverage (93% of municipal CEFs use 5% or more leverage) and Market Price Volatility. Muni CEFs have 92% non-institutional ownership and average only $660K per day in Trading Liquidity. This is why many successful CEF investors are patient and diligent; they are careful to not pay too much or sell too low because the trade "has to happen at the present moment". We can easily take up to a week to make a non-urgent swap between two funds and suggest others take a similar approach. If you miss a trading opportunity, another is likely to arise.
These conservative municipal bond investors typically want 5%-6% total return and care far less about avoiding taxes. Currently our firm manages the clients in each of our Muni CEF models in essentially the same fashion. However, we plan to manage the accounts differently when the FED increases interest rates. For income oriented investors, we will seek to maintain or grow the tax-free cash flow of the account, and for conservative investors we plan to instead protect the risk of NAV or principal loss, expecting to give up income potential.
The philosophies described above are not unique to tax-free CEF investing. We have the same goal for our Equity and Taxable Bond oriented portfolios.
Step 2: How Many Positions to Hold? We advocate for portfolio diversification but not over diversification. As a rule we try to keep positions sized at 4%, 6%, and 8%; rarely do we go above 10% of the account's value. We usually have 10 to 20 positions per account. Every model we run, except our tax-free models, has a blend of US equity, Non US Equity, and Fixed-income CEF sector exposure. We often have 4%-10% of a portfolio model allocated to a tactical or opportunistic strategy. This helps us buy funds that either don't fit into our normal model's allocation, or lets us buy something intra-day that gets unexpectedly beat-up. In both cases, the underlying sector does not necessarily matter to us as we see something we think will out-perform in the short-to-medium term due to the CEF structure and its inherent inefficiencies.
We find it is very common that individual investors and financial advisors only allocate between 0.50% and 2% of an account's value to a given CEF. In our opinion, for an already actively managed investment, it is very hard and overwhelming to track such small positions. It is challenging to think of a way to do this and outperform an ETF or market index.
If you are not sure what to own in the CEF structure, you may want to look at the two ETFs that are nearly 100% CEF focused: PowerShares CEF Income Composite Portfolio ETF (NYSEARCA:PCEF), with about $600M in assets and a 7.8% market price yield, or YieldShares High Income ETF (NYSEARCA:YYY), with about $58M in assets and a 8.14% market price yield - as of 6/12/14. These are not recommendations; we are just acknowledging investment options that will allow you to compare a self-selected portfolio of CEFs to an indexed version. For example, if a 1% position in your portfolio out-performs by +7.5%, then it only adds 0.075% alpha return in the account. Adding in trading cost, market timing risk taxes, this seems like a potentially futile endeavor to add alpha.
At the same time, I have trouble holding more than 15% in any one fund, due to the CEF specific risks like a secondary or rights offering or a large dividend cut. Our most focused model, Special Opportunities, has 5-6 positions at a time and uses 10%, 15% and 20% allocations, but is intended for the risk tolerant investor seeking the opportunity to buy misunderstood or distressed CEFs. I would not suggest this approach for most investors due to the increased risk and potential volatility.
Chart Source: Telemet.
For example, last month Alliance Bernstein Global High Income Fund (NYSE:AWF) cut its distribution from 10 to 8.1 cents per month, a -19% cut. The stock price went from a-1.90% discount to NAV on May 23 to a -6.95% discount on May 27 (the next market day). Surprisingly, the fund posted the same NAV both days. It was not worth any less in actual value, it was just that the future cash flow had been reduced and thus investor sentiment had adjusted the market price by -5%. This loss impacts an account far less when you have a 4% allocation, a -0.20% principal loss, than if the fund was 20% of the account (-1% principal loss). However, in our experience dividend cuts can often be avoided by either monitoring a fund's data or at least its dividend announcement schedule.
Step 3: Manage Your Account: Don't Be Afraid to Sell a Winner or Loser: Essentially each week, we run a report to help us with our CEF Trifecta Analysis: Discounts, Yield and NAV performance comparisons. We decide if a CEF's price is too high to NAV, or if its Earnings are now lagging vs. peer funds. This doesn't not mean we won't buy or sell positions mid-week or that we need to trade every week. We simply look for analysis to confirm each fund is currently the best option for our needs and if not, is the difference enough to make the change? As we have gained more experience with our analysis we have generally increased the threshold required to make changes in our portfolios to seek better alpha inefficiencies between funds.
As a recent example, we are currently having an ongoing conversation with an investor who has seen their favorite municipal CEF (Fund A) narrow from a -7% discount to a current small premium. The fund currently yields about 6.15% and we both agree that it is well managed and has solid bond fundamental data (Earnings, Credit Quality and UNII). However, we suggest swapping into a highly similar fund (Fund B) with an -8% discount and 6.4% market yield. If one had $1M invested in Fund A, you would have $997K in underlying municipal bond exposure and be collecting $61.5K a year in income. Our advice would be to swap to Fund B, and have $1.1M in underlying bond exposure and $64K a year in indicated tax-free yield. In this case, the investor has about $119K in short-term capital gains, but would get $90K+ more bond exposure and an extra $2.5K a year in tax-free income. If you set aside 1/3 of the gain for taxes, you would still have about $50K more in Municipal Bond exposure and have the possibility over time to do similar swapping trades, potentially increasing the tax-free income and growing the portfolio's relative asset exposure. Of course, some trades might end up with losses, but no investor we know as a flawless record. It is not a perfect system, but one that makes sense in our experience and taps into the opportunities provided by the natural volatility and trends of CEFs.
At the same time, we suggest predetermined discount levels or cost basis loss thresholds that trigger a hard review of your investment premise for a CEF. Was the negative movement caused by the sector, the portfolio manager's picks, or discount widening? The easiest way to make money in our experience is to cut losses and let gains run. We know this is very easy to say and can be hard to execute on a constant basis, but we believe the nature of CEFs allows a greater chance of this over time than other investment structures. Some people get excited about a 5 year performance record or when a fund has never cut their dividend rate. Managers and markets are more dynamic and fickle in our opinion. So, we focus on 90 day, 6 months or 1-year data vs. peers to give a more accurate and sensitive picture of a CEF.
Chart Source: CEFConnect.com
Example: We like when a fund's NAV is growing and market price is either stalled or trending down. The fund to the left shows this behavior very clearly. Over the past year the discount has widened, but NAV has increased, while paying a monthly dividend. Source: CEF Connect
Step 4: Set Price or NAV Alerts for Holdings and Your Watch List.
Chart Source: CEFanalyzer.com
There are various discount and price alerts available on many online resources like CEFconnect.com. Login in and set-up alerts under the "My Alerts" box at the top right-hand side of the screen. Our custodian allows us to set up alerts based on trade volume above a certain threshold as well as when a fund passes through a Moving Average or set price. There is an up-and-coming free CEF research site called CEF Analyzer that has a function called "Heat Map", a small section of it is shown to the right, visually showing intraday price movement for CEFs. We look at this page most days to see what is going on with relative value on the CEF universe and where opportunist trades might occur.
Conclusion: I have spent more than a decade thinking and leaning about CEF research and trading, but still find that I learn something new on a regular basis. CEFs seem like the last inefficient frontier in the capital markets; where the patient and diligent investor can wait for an opportunity usually not liquid enough for large institutional investors to take advantage of. We feel that if you can take some time and reasonable effort, you can learn what is normal for a closed-end fund as well and learn about the underlying investment strategies; simply adding good portfolio management decisions on top of the traditional Trifecta analysis.
Further CEF resources: Morningstar has web content covering CEF education as well as The CEF Association. There is a LinkedIn group, (CEF-Network), which has regular posts on events, articles and other industry trends as well as the Morningstar Discussion Forum (Forum's tab on Morningstar's website) on CEFs that has many insightful active CEF conversations. Seeking Alpha has about 15-20 active CEF focused contributors and CEF Insight does a good job covering CEF corporate actions and institutional and activist activity. Our closing advice is to remember to get fundamental data directly from fund sponsor website as they know their data best and pay attention to SEC filings.
Additional disclosure: Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from our June 6, 2014 CEF Universe service.