Equity CEFs: Do Your Due Diligence

Includes: BXMX, ETB, ETG, ETV, SPY
by: Douglas Albo

I have taken it upon myself to try and get investors to evaluate equity based high-yielding closed-end funds beyond just their market prices and dividend yields since I believe there is more confusion that surrounds these funds than just about any other security class. For the past five years, I have invested only in CEFs and ETFs, often in a hedged position, and my outperformance over the S&P 500 since that time is about 130%, so I think I know what I am talking about.*

That being said, I have no control over the market price of these funds. And I can be exactly right in what income strategy is appropriate for the current market environment or what fund's NAVs will perform the best. But if investors don't recognize this and sell funds down to wider and wider discounts or if they want to buy a fund based solely on unrealistic expectations, there is nothing I can do about that. Nonetheless I am convinced that the more I get the word out and inspire investors to "look behind the curtain" and perform their own due diligence on these funds, the more likely they will see things as I see them and the more these funds' market prices will more accurately reflect their NAV performances.

Last Thursday I wrote an article (click here) pointing out which funds' NAVs would hold up best in anticipation of a market pullback and a market pullback is exactly what we got. In two days, the markets gave back the entire week's gain and more. Here are the NAV performance figures for the funds I included in my article which would hold up the best as compared to the S&P 500 and Nasdaq:

JSN: -1.18%
ETB: -1.26%
ETV: -1.16%

S&P 500: -3.58%
Nasdaq: -3.86%

I think most investors could live with a -1% plus loss in their fund's NAV for every -3.5% plus loss in the S&P 500 or Nasdaq, particularly since these funds' NAVs still have further downside protection if the markets continue their sell-off, which looks likely. At some point, if the markets continue their downward slide, the funds' NAVs will drop 1-for-1 with their underlying stock portfolios as their option contracts become essentially worthless, but we're not at that point yet. In such a case when the option contracts become worthless (which is a good thing for these funds), the funds will have earned their portion of their quarterly dividends once again.

It's important to understand how CEF NAVs will react in up and down market environments since the market price will eventually follow the NAV price, even if in the short run, the market price can be subject to the whims and emotions of investors. Many of the funds I recommend include some of the widest discounts among CEFs, ETB at -11.8% discount and ETV at -12% discount, though that should not be taken as a negative indicator since the more the funds get sold off by investors while the NAV continues to hold up, the wider the discount becomes and the more attractive the valuation.

Why The NAV Matters

The Net Asset Value (NAV) of a closed-end fund is the fund's true net worth. It represents all of the fund's assets minus all of the liabilities and is given to you each and every business day after 6 p.m. EST by the fund sponsor, typically by typing an X at the beginning and end of the fund's ticker symbol. So, for example, ETV's current NAV would be XETVX. If the fund sponsor ever announced a reorganization, liquidation, merger or maturity of the fund, it would be based on the Net Asset Value (NAV) per share of the fund, not the market price. Though these events do not happen often, they do happen and investors need to realize what added risk they take on when they buy a fund at a hefty premium or what advantage they receive when they buy a fund at a significant discount, particularly when a fund's income strategy is optimized in the current market environment.

More relevant to investors who look for income from CEFs, a fund's dividend is derived from the NAV and not the market price. Though investors receive their dividend yield based on the market price of the fund, it's the NAV that actually supports the dividend. As a result, investors who buy funds at steep premiums forgo the yield the fund is actually paying and investors who buy funds at wide discounts and earn a higher windfall yield. The ramifications of this are that funds at hefty premiums may be disguising a dividend too large to be supported over time and funds at significant discounts may be having a much easier time supporting their dividend.

Why The Buy/Write Option Strategy Works, Especially Now

I have been recommending the option-income funds, also called covered-call or buy/write funds, to investors for some time now as their income strategy is more optimized in the current volatile and range bound market we have been in for most of this year and I believe will continue for the foreseeable future. Many of these option-income funds continue to trade at close to par to even premiums, but it's the most defensive option-income funds which sell up to 100% option coverage on their equity portfolios and are at more significant discounts that I am recommending to investors in this dangerous market environment. For my picks, see my Thursday article here.

The reason why the covered-call option strategy works is because equity options are a time depreciating asset and time tends to work in your favor if you are short options. In just about every market environment, i.e. a flat to slightly up market, a volatile up and down market and even a mostly down market, favors the option-income fund's income strategy because again time works in your favor as option premium depreciates in all of these market environments. The only market environment that does not favor the option-income strategy is the ramp-up market in which stocks and indexes can rise more than their option premium month after month. For two years from the market lows in March 2009, that is essentially what we saw and this benefited other income strategies over the option-income funds, to a point where most option-income funds had to cut dividends and rebalance their distributions with their income. But all of that has changed now and the option-income funds' NAVs have significantly outperformed their leveraged and dividend harvest fund counterparts for most of 2011. This should be expected in a defensive market environment but even on a longer term basis, investors may be surprised to learn that some of the most defensive option-income funds have outperformed even the major market indexes.

The following tables of two very defensive funds, ETB and ETV show their NAV performances since inception compared to their correlated index, the S&P 500. Both funds are at close to 12% discounts and offer 11% to 11.8% dividend yields. In these tables, the SPDR S&P 500 ETF (ticker SPY) represents the S&P 500. All dividends are added back to the quarterly performance figures to give you a running total of dividends and total return. All information is through September 2, 2011.

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Pretty compelling stuff, particularly when you consider how well these funds' NAVs held up during the worst of the market periods (red) and how well they are holding up currently. So you wonder why investors would want to sell these at the first sign of a market downturn when just about every other CEF I follow has significant more downside, but that is what is happening.

I also wanted to compare one of the funds I am recommending to one of the leveraged funds I identified in Thursday's article as having more significant downside exposure if the market sell-off continues. Just to be fair in my analysis, I will compare one Eaton Vance CEF to another, ETV vs. ETG. The Eaton Vance Tax-Advantaged Global Dividend Income fund ((NYSE:ETG)) is a 27% leveraged CEF which includes 36% domestic stock, 44% foreign stock and 18% preferred stock. Typically, these two funds wouldn't be considered comparable since ETV is 100% domestic stock, but the point I'm trying to make is how an option-income strategy stacks up against a leveraged strategy in a difficult market period as well as over a longer period of time in varying market conditions.

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This table actually took me by surprise since I would have thought that ETG, with a leveraged portfolio, and with one of the better NAV and market price performances of all equity CEFs since the market lows in March of 2009, would have been closer in longer term performance to ETV considering the markets had a lot more green periods than red periods. Still, ETG's NAV performance doesn't even come close to ETV's when you compare the funds over the past 6-plus years, which includes both strong and weak market periods.

Then when you consider that ETG trades at only a -2.8% discount, which is essentially at par, and ETV trades at a -12% discount, you wonder if investors have this backwards. This is one reason why I am short ETG, which historically has traded at a 5-year -9.6% average discount compared to ETV's 5-year -4.0 average. Throw in the fact that ETG's NAV has significant more downside exposure in a weak market (see red periods) and you can see how little sense this makes.

My goal in these articles is to get investors to learn how these funds' NAVs perform in different market environments because in the long run, it can make you or save you a lot of money. Though equity CEFs can be frustrating as their market prices can go to extreme under and over valuations, in my experience, time corrects all imbalances and investors who do their due diligence will be rewarded.

*Results are from a personal trading account. Past performance should not be considered indicative of future results.

Disclosure: I am long ETV, ETB.

Additional disclosure: Short ETG, SPY.