Equity CEFs: Best Opportunity in 2-Plus Years

by: Douglas Albo

I'm seeing some of the best valuations for some equity based high-income closed-end funds (CEFs) since the spring of 2009 and yet investors seem to be oblivious to this and are selling funds at 10%-12% discount levels with Net Asset Values (NAVs) that are holding up better than the broader market.

The only equity based high-yielding CEFs that are outperforming their benchmark indices and earning their dividends in this volatile, range bound market over the past three months have been the option-income funds and that has been the case since the market high on April 29th. The option-income funds (also called buy/write or covered-call funds) are in a win-win situation now because not only is this volatile, up and down market environment more conducive to their income strategy, but the increased volatility as measured by the volatility index could also help these funds with higher option premiums. However, you wouldn't know this by the way some of the most defensive option-income funds are being sold down to 52-week and two-year lows with historically wide discounts. The reason why these funds discounts are widening, however, is not because their market prices are getting hit the hardest, it's because their NAVs are holding up better than their market prices and thus, their discount levels continue to widen.

The following table shows how some of the defensive option-income funds NAV performances have held up since the market high on April 29th compared to the broader market averages and other income strategies such as the leveraged funds and dividend harvest funds. The columns include the NAV prices for the funds at the market highs on April 29 and then the NAV prices from yesterday, July 27, with performance percentages for that time period including all dividends added back. I've also included year-to-date NAV performances as well as premium/discount levels and market price yields for comparison.

Note: Because many of the option-income funds I recommend are from Eaton Vance, I have also included the Eaton Vance leveraged equity based CEFs, ETO, ETG and EVT, for comparison. ETO, ETG and EVT have had some of the strongest market price and NAV performances of all the leveraged equity funds over the past two years, but like all leveraged funds, their NAVs will deteriorate faster in a falling market environment, making them riskier. At the other end of the beta (volatility) spectrum are the Nuveen option-income funds JSN, JLA and JPZ, which represent three of the most defensive CEFs available to investors and are extremely attractive in a negative market environment. The Alpine fund's AOD and AGD use a dividend harvest strategy and are also included here for comparison but I do not recommend them. And finally, some of the funds listed are global and do not necessarily correlate directly to the S&P 500, Nasdaq or Dow Jones Industrial Average. These broad domestic market indices are included for comparative purposes as well.

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This table clearly shows how the option-income funds that I have recommended are holding up far better since the market highs and yet they have some of the widest discounts among CEFs. What's more, their NAV performances YTD are keeping up with the major averages. Now I know what a lot of investors would say about the option-income funds. That their graphs look terrible compared to the leveraged CEFs and thus, the leveraged CEFs are technically stronger. Two things I would say to that. First, technicals don't apply to these fund's NAVs, only the market prices and if investors want to sell these funds at 10%-13% discounts because they look technically weak, then that is their decision. But NAVs don't react to technicals. They only react to the underlying performance of their holdings, so what is important is not which funds have had the best NAV performance over the past two years up until April, but what funds will have the best NAV performance going forward in a changing market environment.

Second, the graphs of the option-income funds are actually much better than they appear when you add back their large dividends. Because option-income funds have some of the largest dividend yields of all CEFs, graphing their market price and NAV does not give you an accurate indication of how these funds are truly performing because their large monthly or quarterly distributions are not included. The following two graphs of one of the option-income funds I have been repeatedly recommending, the Eaton Vance Enhanced Equity Income fund II (NYSE:EOS), is shown below. If you looked just at the fund's actual market price and NAV since inception in early 2005 (first graph), you would think that EOS has been a disaster since both its market price and its NAV price are not that far above even the market lows back in March, 2009. It's only when you look at EOS' market price and NAV performance adjusted with its monthly dividends added back (second graph), that you realize that the fund has actually performed quite well and has had similar total return performance to the S&P 500, all the while including a defensive covered-call option strategy.

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Source: Historical data from Yahoo Finance and CEF Connect

So why would an investor sell a monthly pay CEF with a sustainable 9.7% yield at a 10.5% discount, the widest it has been in years, and whose option strategy will hold up better in a down market environment? Good question. If investors are concerned about a correction in the market, then buying or holding these defensive, high-yielding CEFs and shorting the major market ETFs such as the SPY, QQQ or any correlated ETF is a better strategy, in my opinion. I would recommend no more than one-third of a portfolio be hedged with correlated ETFs since ETFs will react quicker to market moves than CEFs even if CEFs can make larger percentage moves. This has, in essence, been my strategy for the past five years and I have far outperformed the markets over that period of time.*

In a worst case scenario, if we go into a bear market environment, then even the defensive option-income funds will go down in value. Though it should be noted that for many of the funds I am recommending that are at 10%-plus discounts, the Dow Jones Industrial Average would need to drop an additional 1,000 to 1,500 points before these funds NAVs would catch up to their current market price levels.

*Past performance should not be considered indicative of future results.

Disclosure: I am long ETW, EOS, ETB, ETG, EVT, ETO, JSN.

Additional disclosure: Short SPY, QQQ