Return of Capital (ROC) is one of the most contentious subjects surrounding closed-end funds and so it is interesting to see how ROC can be so controversial for some funds and no so much for others. I receive more comments from readers concerning Return of Capital on the funds I write about than any other subject. For most investors, it is the single biggest reason to avoid a fund since most readers believe that a high ROC percentage is simply the fund returning an investors principal back to them. So why is it that for many funds, ROC is considered a negative but for others, it doesn't seem to matter based on the premiums investors are willing to pay for such funds?
Take for example, the Gabelli Utility Trust (GUT) and the BlackRock EcoSolutions Investment Trust (BQR). Both are stock based high yielding closed-end funds that have very high Return of Capital percentages in their distributions and yet trade at exceptionally high premiums. Trying to find the reasons for this are difficult and it is alot easier to find reasons why they shouldn't trade at premiums at all. About the only similarity these funds share is that they both have sector specific stock portfolios and I will get into the significance of this later, but for now, let's take a look at each fund.
Gabilli Utility Trust (GUT)
Inception Date: July 9, 1999
Inception NAV: $7.50
Current NAV (May 13, 2011): $5.74
Current Price (May 13, 2011): $7.20
Current Price Yield: 8.3%
Dividend Amount/Share: $0.05
Dividend Frequency: Monthly
Dividend Strategy: Leveraged
Market Cap: $185 Million
BlackRock EcoSolutions Investment Trust (BQR)
Inception Date: September 26, 2007
Inception NAV: $19.06
Current NAV (May 13, 2011): $10.63
Current Price (May 13, 2011): $11.99
Current Price Yield: 10.0%
Dividend Amount/Sharet: $0.30
Dividend Frequency: Quarterly
Dividend Strategy: Option-Income
Market Cap: $131 Million
Let's first take a look at GUT. GUT uses a leveraged strategy to support its high dividend, currently using about 22% leverage according to CEFConnect.com. What's interesting about this strategy is that GUT relies much more on portfolio appreciation to pay its 8.3% current yield than from its portfolio dividends. One might expect that a utility fund would have a high dividend income from its portfolio but in fact, GUT only derives 11% of each distribution from investment income according to GAMCO's Investor website. The rest of each dividend is coming from capital gains and/or losses and since GUT has a very low turnover rate of only 1%, its coming from mostly unrealized capital gains and/or losses. As a result, 89% of every dividend GUT has distributed since 2009 has been determined to be Return of Capital.
And has this high ROC percentage acted as a drag on the fund's market price performance? Apparently not. In fact, GUT's market price rose to a 75% premium over its Net Asset Value (NAV) in the summer of 2010 until an announcement of a dividend review in August last year clipped that absurd premium down to roughly 20%. Eventually the dividend was lowered from $0.06 per share to $0.05 per share beginning in January, 2011 but the fund continues to reflect an overly generous premium of 25%, 4th highest of all equity based CEF's.
Now let's take a look at BQR. BQR uses an option-income strategy typical of many other equity-based high yielding CEF's. This strategy has not been in favor the last couple years since option-income fund NAVs don't appreciate as much as the broader market during a bull market cycle. As a result, most option-income funds have been trading at wider discount levels to their NAVs, some as high as 10%+ discounts. Combine that with the fact that most option-income CEFs have high ROC percentages and one wonders what it is about BQR that separates it from the rest? Option-income CEFs generally have high ROC percentages because they can pass on the losses they realize from their covered-call option strategy as ROC during a bull market cycle. As long as the fund holds onto its unrealized portfolio gains and doesn't offset those gains against their realized option losses, each distribution can be designated as mostly ROC.
So why does BQR receive such a high premium as an option-income fund when 100% of its latest distribution was classified as ROC? In a BlackRock press release dated March 31, 2011, BQR's 1st quarter distribution was 0% net investment income, 0% net realized short term capital gains and 0% net realized long term capital gains. 100% was estimated to be Return of Capital. Then you look at BQR's NAV performance and you wonder what is so special about this fund to deserve a premium at all.
I don't mind if a fund earns a premium for superior NAV performance, but BQR hardly falls into that category with an NAV up only 7% for 2010 and only 1% year-to-date (including dividends). If you back out the1st qtr dividend from March, BQR's NAV is actually down on the year. Compare that to the S&P 500's gain of 14.9% for 2010 and 6.9% YTD and there is no reason why BQR should receive the high valuation it does. In fact, I could rattle off a dozen other option-income CEFs that have had far better NAV performances year-to-date with similar 10% current yields but yet trade at 5%-10% discounts compared to BQR's 12.8% premium. If option-income funds are to be penalized for their income strategy during a bull market cycle, then this should reflect on all funds. A valuation difference of this magnitude for an underperforming fund is frankly, absurd.
GUT, on the other hand, has had strong NAV performance over the past two years due to its leverage but does it deserve a 25% premium for that? Every leveraged equity based CEF has had a strong couple years, many with much better NAV performances than GUT with its portfolio of utility stocks. And yet no other leveraged only equity fund trades at a premium. In fact, most trade at 7%-12% discounts which is more typical of leveraged CEFs due to their enhanced risk of leverage and lower yields compared to other income strategies. When you combine that with GUT's unusually large ROC percentage and just how has this fund managed to achieve a 25% premium, let alone a 75% premium at one time?
I wonder how much of GUT's premium is based upon investors' assumptions that the fund includes a portfolio of conservative, high dividend paying utility stocks that offers relative safety? This could not be farther from the truth. Any time leverage is used, the risk goes up substantially, even for a portfolio of utility stocks. Combine that with the dividend being predicated more on portfolio appreciation than investment income and GUT becomes not much different than any other leveraged CEF that relies heavily on portfolio appreciation to cover its dividend.
Investors might argue that an 8.3% yield from a utility fund paid monthly is still attractive no matter how it earns it. What investors don't realize is that when the $0.60 annual dividend per share is applied to the NAV, which is a much more accurate barometer of what the fund is actually paying, the current yield jumps to 10.3% based on GUT's $5.74 NAV as of May 13, 2011. That is an extremely high yield for a leveraged fund and is a big reason why GUT lowered its dividend earlier this year in the midst of a strong bull market. Though I don't anticipate another dividend cut anytime soon, if we go into a more difficult market cycle in which GUT's reliance on portfolio appreciation rather than portfolio yield becomes more critical, then nothing can be taken off the table.
The point of this article is to stress how arbitrary closed-end fund market price valuations can get based on factors that have little to do with the fund's actual fundamentals. Even a high ROC component which for most funds would be considered a negative can be brushed aside for others. This is not the first time that I have seen investors flock to funds based on what is considered to be a popular sector or a safe sector while disregarding actual NAV performance or other negatives that may affect NAV performance. In January of this year, I wrote an article on the ING Risk Managed Natural Resources fund (IRR) and how its NAV won't appreciate much even if every natural resource sector like oil, gas, gold, copper goes through the roof because it's collar option strategy of selling covered-calls and buying puts won't allow it with the current strategy. I pointed out how, in fact, on a pure price basis, IRR's NAV is actually lower today than at the market lows in March of 2009 and yet IRR still trades at a premium. In the case of BQR, EcoSolutions is a nice buzzword and makes for a nice marketing tool, but it's done little to allow BQR to outperform other option-income CEF's or to have a higher yield or a lower Return of Capital.
The fallacy of investing in these funds because they invest in a popular sector while ignoring any other factor is a strategy destined to fail. For investors who specialize in these funds, these anomolies can be a source of frustration as well as opportunity. The stock market was once described as a voting machine in the short run and a weighing machine in the long run. In other words, in the short run, anything can happen. But in the long run, the true weight and valuation of an investment will be revealed and in the case of closed-end funds, it becomes even more assured if one follows the Net Asset Value.
In case any investor thinks that a fund like GUT will always be held in high regard and will always trade at a premium, I would call to their attention another leveraged utility fund that not long ago traded at huge premiums too and also earned the accolades of a fund that could do no wrong after a series of dividend increases from 2005 through 2007. The Wells Fargo Advantage Utilities and High Income fund (ERH) was once known as the Evergreen Utilities and High Income fund and earned premium valuations as high as 30% for much of 2007-2008. Eventually, however, NAV erosion due to leverage in a more difficult market environment resulted in dividend cuts and the fund fell into disfavor. Though ERH was a more aggressive utility fund back then using even higher leverage compared to GUT, the point is that investor devotion to closed-end funds can be fickle and can turn in a instant, particularly when a fund trades at a lofty premium to its true net value. Currently, ERH trades at a 5% discount as it tries to build back up its NAV and reclaim those glory days from only a few years ago.
Disclosure: I am short GUT.