This is a continuing series of analysis on individual or similar class equity-based high-yielding Closed-End funds (CEF’s) that standout for one reason or another. I have focused on these funds in my Advisory business because CEF’s offer three advantages that most other investments do not.
- They can trade at discounts and premiums to their Net Asset Value (NAV) which makes their valuation more definable and gives an advantage to more sophisticated investors who perform due diligence.
- They offer high yields of recurring income no matter what the market environment.
- CEF’s are diversified like a mutual fund or ETF but yet can trade like a non-diversified individual stock, thus offering more tradable opportunities.
This is not to say that CEF’s are easy securities to invest in. CEF’s can be frustrating at one moment and exhilarating the next. Often times, CEF’s can trade at irrational valuations, either positive or negative, but that is where the opportunity lies for investors. Much of my analysis on these funds has to do with their relative valuations and whether the fund(s) are appropriately market priced in current market conditions.
This article focuses on the ING Risk Managed Natural Resources fund (IRR). Let’s start with the basics.
Stat sheet-As of 1/24/11
Inception Date: 10/24/2006 Current Market Cap: $335 Million Inception Price: $20.00 Current Price: $15.64 Inception NAV: $19.06 Current NAV: $14.82 Inception Yield: 8.92% Current Yield: 9.28% Income Strategy: Option-Income Discount/Premium: +5.53%
A few weeks ago I wrote about how high-yielding equity based CEF's utilize three basic strategies to generate their income which they pass on to investors in the form of high dividends and yields. These three strategies include the option income strategy, the leveraged strategy and the dividend harvest strategy. Two of these strategies excel in a strong up market while the other is a more defensive strategy. Currently, the leveraged strategy and the dividend harvest strategy are far and away the favored strategies as the expectation of a continued bull market has pushed many of the leveraged and dividend harvest CEF's to reduced market price discounts and even to premiums from their NAV's.
On the other hand, the option-income funds have continued to languish and their discounts have continued to grow to mid- to high-single digits as they have fallen into disfavor for the more risky leveraged and dividend harvest funds. Whether this continues or not remains to be seen, but the trend has certainly been established.
So it is a surprise when you see one option-income fund bucking the trend and trading at a premium when, in fact, it is probably the least likely option-income fund to be reflecting such a high valuation.
There is no further proof of the misunderstandings that go on in equity-based high-yielding CEF’s than what is going on with IRR. As its name implies, IRR only owns natural resource stocks in sectors such as integrated oil and gas, oil services, chemicals, diversified metals and mining. Most of these sectors have had strong market performance since the market lows two years ago and this has obviously contributed to investor interest in IRR and its high valuation. The Top 10 holdings and sectors are shown below.
It’s when you look at the fund’s strategy to reduce risk and generate income that the high valuation makes no sense in a continued strong market environment. Not only does IRR utilize an option-income strategy which, as noted above, has fallen well into disfavor, but IRR is one of the few option-income funds that also buys index put options for further downside protection. So not only does IRR sell index call options on 70% of its portfolio to generate much of its income for dividends, it uses some of that income to buy index puts on 100% of its portfolio value as well!
This would be great in a down market environment and it certainly helped IRR keep a relatively high NAV during the market fallout from late 2007 to early 2009, but the last two years have seen a mostly bull market environment and funds such as these have generally been disregarded by investors. The end result over the past two years is that IRR’s NAV has dramatically underperformed the markets even though natural resource stocks have done very well. In 2010, the NAV was up only 0.19% including dividends. This is much worse than even the pure play option-income funds which mostly underperformed their market indices as well, but not nearly to this degree.
So why do investors continue to support IRR into a premium valuation while just about every other option-income CEF I follow is at discount levels not seen since the spring of 2009? I can only imagine it’s the words "Natural Resources" which makes investors think they are getting the upside that those sectors represent. If only the fund’s NAV were keeping up with the fund’s market price, then their enthusiasm might be justified. Unfortunately, IRR’s NAV on an absolute performance basis is actually LOWER today than it was at the market lows of March 2009! Throw in the $3.13 that IRR has distributed since the market lows and IRR’s NAV total return is up a measly 19.6%. That’s with distributions though not on a reinvested basis. Compare that to the energy ETF (XLE) which is up about 80% since the market lows and you see why IRR has NO reason to trade at such a relatively high market price valuation when other defensive CEF’s which have had MUCH better NAV performance and with similar yields trade now at wide discounts.
Investor’s may be thinking that they are enjoying the ride up in oil, coal, gold and other natural resource stocks while getting paid a 9%+ yield, but they are not even close. The fact of the matter is that natural resource stocks could go straight up from here and IRR's NAV will not participate, unless ING changes the investment strategy and drops the buy put component.
The point I’m trying to make in this article is how unsophisticated investors can get lured into funds that on the surface seem to have all the right stuff. Though IRR has traded at even higher premiums over the past few years than its current 5.5% premium, the problem now is that it's relative valuation to other option-income funds is way out of whack. In other words, if current market conditions were more bearish, then IRR's premium might make more sense since the more bearish a market could get, the more IRR's NAV would outperform. Unfortunately, market sentiment is for the risk trade at the moment and IRR does not fall into that catagory, unless you consider the risk of buying an option-income CEF at a 5.5% premium to its NAV when most other option-income funds are currently at 5%-10% discounts.
My recommendation to income seeking investors in equity-based high-yielding CEF's is that they pay more attention to the NAV of a fund rather than it's market price and yield since the NAV will tell you where the fund's market price is eventually headed. And by all means, pay more attention to words such as "Risk Managed" rather than "Natural Resources."