Reorganization Of Nuveen Equity CEFs: Good Or Bad For Shareholders?

| About: Nuveen Nasdaq (QQQX)


Nuveen has opened the vote on reorganization of several of its domestic equity, option-income, closed-end funds.

Four new funds will emerge post-reorganization. Three will follow a "dynamic" options strategy. One will use a "complete" options strategy with total coverage of the portfolio by options.

The new funds will be pegged to the major US market indexes: S&P 500, Dow Jones 30, and the Nasdaq 100. I focus here on the latter.

Following the path laid out in a preliminary proposal a few months ago (as discussed here), Nuveen has now opened the voting for reorganizations of several of the domestic equity, option-income funds in its array of closed-end fund offerings.

This chart describes the reorganizations as they were proposed.

The reorganizations were proposed to create 3 new funds (BXMX, SPXX and DIAX) that will provide option-income strategies tagged to the S&P 500 and the Dow 30. BXMX is the only one of the new funds that was proposed to use a complete options strategy with 100% coverage of the portfolio.

One existing fund, NASDAQ Premium Income & Growth Fund (NASDAQ:QQQX), was proposed to remain. QQQX follows a dynamic option strategy (30% to 50% option coverage) designed to track the Nasdaq 100 with reduced volatility. QQQX was slated to absorb Nuveen Equity Premium Advantage Fund (JLA), which tracks a blend of the S&P 500 and Nasdaq 100, and has complete option coverage.

The remaining funds were proposed to go with the same dynamic options strategy, applying it to the S&P 500 and Dow 30.

It's the QQQX-JLA reorganization that I want to concentrate on in this article. Nuveen's proposal to merge JLA into QQQX does appear to be effectively what will happen if the votes for reorganization are approved. JLA's investment objectives will be abandoned and replaced with a slightly modified version of QQQX's. One might have expected a more consistent approach to this conversion would have moved JLA's assets (and shareholders) into the sole complete-coverage fund, BXMX, which it most closely resembles; but, for whatever reason, that is not what Nuveen has chosen to do.

The new version of QQQX will be called Nuveen NASDAQ 100 Dynamic Overwrite Fund. There is no ticker symbol announced for the fund at this time, but the preliminary proposal suggests that it will retain QQQX. Because this is not clear in the proxy statement, I will, for the purposes of clarity in this article, be calling it NDOF for the convenience of distinguishing the existing QQQX and the newly reorganized NASDAQ 100 Dynamic Overwrite Fund. (NDOF is, of course, not a real symbol so I've set it in italics to make clear that it is a fictitious convenience.)

What will the new fund look like?

JLA holds net assets totaling $235.766M (Source: QQQX holds $351.874M. The new fund would come in at $587.64M at today's values. This would place it at the 26th percentile of cefconnect's universe of domestic covered-call and general equity funds. Based on QQQX's current distribution rate of 7.25%, it would be at the 62nd percentile of that group. JLA pays a slightly higher 7.93%, but as the new fund will more closely resemble QQQX, that fund is probably a better benchmark for setting expectations. JLA's higher distribution rate is also driven in part by its lower discount. NAV distribution rates for the two funds are 7.40% for JLA and 7.09% for QQQX. So while JLA gains a half point on its discount, QQQX's discount is only enhancing its distribution rate by 16 bps.

Nuveen describes two options strategies for the present funds: A "constant" options strategy, where options are sold on the entire value of the underlying stock portfolio. This is the strategy employed by JLA. The other is a "dynamic" options strategy, where call options are written on between 30% and 50% of the fund's underlying equity portfolio. This is QQQX's mandate.

JLA seeks to replicate the price movements of a blend of the S&P 500 Index and the Nasdaq 100 Index. QQQX seeks to replicate the price movements of the Nasdaq 100 Index. NDOF will seek to replicate the price movements of the Nasdaq 100 Index, and will use a dynamic options strategy. It will target an options overwrite level of approximately 55% over time, which may vary between 35% and 75%, based on market conditions. Thus, the new fund will look much like QQQX, with slightly more latitude in its dynamic options mandate.

A Look At Recent Performance: JLA and QQQX

Let's begin by comparing the recent performance histories of JLA and QQQX. As seen in this one-year chart (from YCharts), QQQX has had a good year, outperforming JLA and generally keeping pace with Powershares QQQ Trust ETF (NASDAQ:QQQ) for total return. JLA has been particularly sluggish since about the time of the initial announcement of the proposed reorganizations.

QQQX is a bit off QQQ's performance recently, but half of that differential has come from a downward move in the discount; on an NAV basis, it's much closer to its target. This can be seen in the next chart (from Yahoo Finance), which includes the NAV ticker (XQQQX, green line).

QQQX is, as expected, more volatile than JLA. The reconfigured fund will certainly more closely resemble QQQX in this regard than JLA. That is an inevitable consequence of the dynamic vs. complete options strategies. Again from YCharts, here's a chart of 30-day rolling volatility for QQQX and JLA:

How Will The Conversion Happen?

Shareholders of JLA and QQQX will receive shares in NDOF based on the ratio of their funds' NAVs over NDOF's NAV. How the market price will be determined is up to the market. Today, the market has priced JLA at a -6.98% discount and QQQX at a -2.31% discount. Considering that the new fund will be, in most ways, identical to QQQX, the overall benefit would appear to be to JLA shareholders, who will receive QQQX's assets (and investment strategies) at JLA's more discounted price. This is just as the initial proposal implied. QQQX's shareholders would seem to me to neither benefit greatly nor suffer any losses. Their fund will grow by 40%, but will be otherwise unchanged.

Nuveen seems to agree with this assessment of the relative benefits to JLA and QQQX shareholders. The proposal up for a vote by shareholders puts essentially the entire cost burden of the reorganization on JLA. There will be a cost of $525K charged to JLA's NAV vs. only $10K charged to QQQX's NAV. For JLA's shareholders, the cost amount to about a 0.15% charge to NAV; for QQQX, it rounds to zero. Nuveen states the costs are being allocated asymmetrically, because the benefits to JLA shareholders exceed those to QQQX shareholders:

"The allocation of the estimated costs of the Reorganizations is based on the relative expected benefits of the Reorganizations including forecasted cost savings and distribution increases, if any, to each Target Fund during the first year following the Reorganizations, as well as the potential for improved secondary market trading…" (Source)

While I accept that there should be benefit to JLA shareholders accruing from the discount differential, I do not see how Nuveen can use "distribution increases" as part of its justification for putting the whole burden on JLA's shareholders. JLA has a higher distribution rate than QQQX on either a market or NAV basis, so it seems more likely that JLA shareholders will take a bit of a hit on distribution yield.

One last point on the mechanics of the reorganizations, before I move on. I've only considered JLA and QQQX here. As seen in the top graphic, five additional Nuveen equity-income funds are being reorganized: Equity Premium Income Fund (JPZ), Equity Premium Opportunity Fund (JSN), Equity Premium Income & Growth Fund (JPG), Dow 30 Premium & Dividend Income Fund (DPD), and Dow 30 Enhanced Premium & Income Fund (DPO). Three additional new funds are being created to absorb those assets. Each of these events is subject to approvals by the funds' shareholders.

Assuming the reorganizations hit no roadblocks, conversions are expected to take effect on September 29, 2014 or soon thereafter.

Benefit to Shareholders

Nuveen claims the following potential benefits in the proxy statement (cited above):

"i. reduced fees and expenses over time as a result of economies of scale from a larger combined fund and an agreement … to reduce the management fee... by two basis points …;

"ii. better liquidity and reduced trading costs from the greater share volume of the combined fund...

"iii. stronger demand from a simplified, differentiated product set, which may lead to narrower discounts over time..."

The two basis point reduction in fees is nice, but hardly something that will generate dancing-in-the-street levels of celebration. The second point appears to me to be the most favorable of the three. As for the third, I'm not convinced the reorganization will have a great impact on discounts one way or another for JLA and QQQX. CEF investors are generally quite conscious of discounts or premiums; many simply expect a discount in any fund they decide to buy. Market forces tend to equilibrate CEF returns (especially distribution rates) by adjustments of premium/discount levels. If Nuveen is really putting a priority on discount reduction, the way to achieve that is to increase performance sufficiently to increase distribution rate with no cost to NAV. That's harder, of course. The fund, as presently configured is trailing almost two-thirds of domestic equity CEFs in this metric. I would not expect any marked compression of discounts without an increase in distribution rate on NAV coming first.

For anyone holding JLA and who might be looking at QQQX's relative outperformance, the conversion provides a tax-free swap from JLA to QQQX, and throws a bit of a discount into the bargain. On the other hand, someone wanting to retain JLA's constant overwrite strategy will be force to sell the new fund and purchase something like BXMX.

What Next?

I hold JLA, and back in May, I increased my stake a bit in anticipation of a small windfall with the reorganization. Looks like that may happen, soon after or maybe soon before the 29 September target date. In retrospect, I'm not convinced it's turning out to be that smart a trade. JLA has turned in mediocre performances since the announcement, and that money may have been more effectively invested elsewhere (I have got to figure out some way to get that rear-view mirror to face forward).

On the other hand, I did own JLA at the time of the announcement, and I was not looking to sell. So that part of my holding will benefit. The additional purchase should turn out all right as well, just not to the extent I'd anticipated.

Bottom Line

I'll certainly be voting for reorganization. While I'm not thrilled with the proposal, nor am I convinced it fully considers the interests of JLA shareholders, I am concerned that if the reorganization fails (an extremely unlikely event, in my view), the target funds will suffer consequences from that failure. If you feel differently, please let us know.

Whether or not I'll want to hold NDOF (or QQQX, or whatever the new fund's symbol may be) is very much an open question in my mind. Holding QQQ is probably not a bad place to be right now for a domestic equity allocation. Its growth slump predated (predicted?) the broader market's trends that followed, so I'm thinking it will be a harbinger of the coming turnaround to the upside (ever the optimist, I am). So, holding a QQQ proxy that pays out income, which is something I welcome at this stage of my investing life and moderates volatility to some extent, is not an unattractive position.

On the other hand, I was in JLA for its strongly defensive strategy of complete coverage of the portfolio with options. Not so sure I'd willingly move out of that defensive posture in an equity environment that seems to be calling the defensive team to the field.

For shareholders of QQQX, it looks to me like a wash. I don't see that they are giving anything up by getting the infusion of JLA's capital into their fund. There are certainly enough opportunities in the Nasdaq 100 that another quarter gigabuck or so shouldn't cause management to falter. On this front, I agree with Nuveen's assessment. But I don't really see any great benefit. The net result is that the fund will get larger by 40%, fees will move down a mite, and life will go on.

I haven't looked at all at the other five funds and their reorganizations in any detail, so I cannot comment on them here. I would be delighted if others who have interests in those funds enter the discussions with their concerns on the proposals.

Disclosure: The author is long JLA. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.