From time to time, particularly when investors may be interested in funds going ex-dividend soon, I like to compare high-yielding equity-based Closed-End funds (CEF's) with one another to show some of the inconsistent valuation differences investors place on funds and how investors can often miss the big picture when it comes to investing in CEF's. In this article, I'm going back to comparing an option-income strategy fund with a dividend-harvest strategy fund to show investors how one strategy performs compared to the other. I first compared these two funds back in January and nothing really has changed other than the valuations investor's place on these funds continues to defy logic.
The first fund is the Eaton Vance Tax-Managed Global Diversified Equity Income fund (EXG), an option-income fund that also happens to be the third largest equity CEF at $3.15 billion in assets. EXG is a global equity fund which sells index options on 48% of the notional value of its stock portfolio to earn premium that it passes on to investors in the form of large dividends and yields. 48% is a relatively low coverage percentage which means the fund also relies on portfolio dividend income and appreciation to help pay for its $0.2843/share quarterly dividend.
The second fund is the Alpine Total Dynamic Dividend fund (AOD), also a well-known and large $1 billion+ global equity high-yielding CEF. AOD's dividend harvest income strategy is much different than an option-income funds and is designed to "capture" multiple dividend periods by overweighting equity positions on a rotating basis ahead of their ex-dividend dates. The end result is increased amounts of investment income that the fund also passes on to investors in the form of tax-qualified high dividends and yields.
Both funds are controversial, but for different reasons. EXG has a high Return of Capital (ROC) percentage which seems to be a red flag to many investors and analysts and AOD employs an income strategy that is unique and still unproven among high-yielding equity CEF's. Both funds have been forced to cut dividends over the past two years due to market conditions, EXG by 40% over two cuts (from $1.90 to $1.53 to $1.14 annualized) and AOD by a much larger 69% also over two cuts (from $2.16 to $1.44 to $0.66 annualized). Here are the relevant statistics. Information is from CEFConnect.com, Yahoo! Finance and annual reports and is as of 8/12/2011 except where indicated.
The reason why I am comparing these two funds is because their similarities allow me to highlight their primary difference, i.e. the effectiveness of their income strategy for investors. Both are global stock funds (EXG is 60% international / 40% U.S. vs. AOD's 63% international / 37% US) and both came public within a month of each other in 2007 at the same inception price and the same inception NAV (see table above). Though the two funds obviously have different global stock holdings and different country weightings, the primary difference between the two funds is their income strategy and this has been the primary driver for their wide variance in performance. I have argued that option-income funds are performing much better than Investors and analysts believe and in the current volatile and defensive market environment, the option-income strategy is the only strategy that is outperforming and earning their dividends.
But even if you forget about current market conditions and just look at performance from the inception dates of these two funds, the Total NAV Return over bull and bear markets should convince you which fund has been far superior in holding NAV value for investors. Both funds were only able to enjoy a few quarters of an up market period before the bear market of 2008 hit so both funds show a negative total return since inception which is not unusual for CEF's which went public around the same time. What is unusual is how investors continue to misread the prospects for these funds based on the discount/premium valuations they assign to each fund. The following table shows the quarterly NAV values starting from EXG's inception date of 2/23/2007 which was the later of the two funds by a month. All dividends and distributions are added back (not reinvested) and a running tally of both dividends/distributions and NAV total return performance is shown. Note: AOD's inception NAV of $19.07 on 1/26/2007 had grown to $19.47 on 2/23/2007 and also accounts for the slight performance difference from inception.
If you are surprised to see that a fund that typically trades at a wide discount could so dramatically outperform a fund that typically trades at a premium, then you are not alone. The bottom line is that since inception, these two funds started with the same market price and Net Asset Value and have ended up with far different results through bull and bear markets alike. And this is with similar annual dividends and dividend yields too. In fact, in just about every category except for dividend frequency, which I like the monthly pay better, EXG shows a solid advantage. And yet, when the market gets defensive, which of these funds do you think investors bail from first?
What's even more amazing is that EXG's modest -7.6% total return NAV loss not only trounces AOD's -33.8% NAV loss, but EXG's NAV performance is actually better than the S&P 500 average over the same period. That's right ... EXG's NAV from inception has outperformed the S&P 500 on a total return basis. Though the S&P 500 would not necessarily be a global fund's benchmark index to compare against, I still think it is relevant to show how EXG's NAV has performed far better than what most investor's or analysts would believe.
And what has EXG earned for this outperformance? Investors have taken EXG down to a -12.2% market price discount to its NAV, one of the widest of all the equity CEF's I follow. Now EXG is not the most defensive option-income fund and its NAV will depreciate faster than many other option-income funds in a difficult or bear market environment, but it is certainly more defensive than AOD or the other dividend harvest funds and most of the leveraged funds. And in this volatile market which has quickly become more dangerous to investors, option-income funds at least allow some measure of downside protection while they earn their dividend. In contrast, option-income fund's NAV's will underperform other CEF income strategies during a ramp-up bull market like we saw during most of 2009 and 2010, but I think investors are starting to realize that we are not going back to that any time soon. Even if volatility comes down after the recent spike and the markets become more range bound instead of ramp-up, this benefits the option-income funds more than any other income strategy.
So I ask you, which of these funds would you rather own in this more dangerous market environment? Based on investor sentiment as reflected in discount and premium levels and market price performance, incredibly investors still seem to want to own AOD over EXG. Here is a 1-year chart of market price performance for EXG and AOD (dividends not included but would have increased both fund's market price performance by roughly 12% or so).
Perhaps the fact that we were still in the midst of a strong market during most of the past year and the fact that EXG did make its second dividend cut in December of 2010 probably combined to drag down EXG's market price performance. But now that we are in a more defensive market environment with volatility and option premiums up, shouldn't investors be looking at funds like EXG in a better light? Maybe not based on EXG's widening discount level even as it's NAV outperforms. Here is EXG's 1-year Premium/Discount level.
Pretty stunning for a global fund whose NAV is down only -4.7% year-to-date compared to -5.3% for the S&P 500 and a whopping -9.4% for AOD (dividends included). And how has EXG's market price performed YTD compared to AOD's even though EXG's NAV has far outperformed AOD's over virtually any time period? EXG's market price is down -8.7% YTD while AOD is down only -3.6% (again, dividends included). Frankly, it's almost laughable the valuation difference that investors place on one fund that has never been able to prove itself while the other has held up far better and has even outperformed the S&P 500! I would urge investors to take advantage of the opportunity in EXG because at some point, larger investors are going to realize what I have been saying for the past few months, that the option-income funds are the only funds whose income strategies are working now and earning their dividends.
On the other hand, what is it that compels investors to want to own AOD with its disastrous historic NAV performance? Do investors really believe that AOD is finally going to turn things around now and that they should jump in at the first sign of market stabilization? Apparently so. Here is AOD's market price performance compared to EXG last week.
Perhaps I'm misinterpreting last week's action and AOD is simply more volatile than EXG and investors are just looking more for a short term trade. Right? Please don't tell me that investors think that AOD now presents a great opportunity at a -1.12% discount to its NAV which I guess is historically 'wide' compared to the absurd 40% premium it used to have! Frankly, any long term investor would be making a big mistake to believe that AOD or any of the dividend harvest funds have long term potential based on their history. Another dividend harvest fund, the First Trust Active Dividend Income fund (FAV) has cut its dividend twice over the past 9-months, most recently in July, and yet it still seems to earn a better valuation than EXG at only a -5.3 discount. I'm beginning to think that investors have some sort of bad relationship syndrome with the dividend harvest funds that makes them want to keep going back to them in hopes that it will finally work out!
Now EXG is not without its issues. Like the leveraged and even the dividend harvest funds, EXG relies more on stock selection and stock appreciation than many other option-income funds that have higher option coverage on their portfolios. When the fund has a subpar year like in 2010, NAV underperformance can be more extreme. So far in 2011, EXG has turned that around. Dividend sustainability is also a major concern for investors and a bear market could not rule out another dividend cut in the future. But I would argue that EXG's income is more balanced with its distribution now than at any time in the last two years due to its dividend cuts and I can certainly think of many other funds, AOD included, that would be more at risk of a dividend cut than EXG if we go into a bear market. One indication that a fund may be at risk for a dividend cut is when the fund's NAV yield is over 12% and its income strategy is out of favor. Neither of these apply to EXG currently although both apply to AOD. The other issue facing EXG in the minds of investors is Return of Capital (ROC). ROC is more pervasive in option-income funds because of their income strategy, but this is not as big a negative as investors believe. I would argue that if ROC is so negative, why have so many option-income funds with high ROC been able to outperform ETF's such as the S&P 500, which is what most funds use as their benchmark to compare performance against? I have written extensively on the subject of ROC and one of my past articles tries allay these concerns.
Finally, EXG is a quarterly pay fund which goes ex-dividend on Monday, August 22nd meaning an investor would have to own the fund by Friday, August 19th to be entitled to the dividend.
Disclosure: I am long EXG.