2011: A Year To Forget For Equity CEFs

by: Douglas Albo

2011 will go down as a difficult year for many high-yielding, equity-based closed-end funds (CEFs), as most funds either saw their discounts widen or their premiums reduced. In fact, this year has made little sense in regards to market price action, as many funds with outperforming NAVs have seen their market prices drop to their widest discounts since the bear market in 2008, while some have continued to trade at lofty premiums even with underperforming NAVs. No one ever said CEFs have to make sense, and this year has been a year in which the efficient market theory was turned upside down.

The following tables show YTD NAV and market price performances of most of the high yielding equity CEF funds available to investors. The tables are broken down by the 3 basic income strategies these funds use to generate income which they pass on to investors in the form of high distributions and yields. (If you're not familiar with how these 3 strategies work, you can read about them here.)

Funds that have NAVs which are outperforming the S&P 500 YTD, as represented by the SPDR S&P 500 ETF, SPY, are shown in green, and those that have underperformed are shown in red. Though many of these funds are global and do not necessarily correlate with the S&P 500, the S&P 500 is still the most recognized benchmark for comparison. I have also included "red flags" for funds which have either 1) overly high expense ratios, or 2) overly high premium prices and 3) overly high NAV yields. Note: NAV and market price performances include all distributions added back but not re-invested.

Click tables to enlarge.

What I find most interesting is that many of the option-income funds (first table) have outperforming NAVs for 2011, but virtually all of them are in a current downtrend in their discount/premium cycle. In fact, over half of the option-income funds that have outperformed the S&P 500 have dropped to double-digit discounts. Part of their poor market performance may be end-of-year tax selling but many funds have been suffering with widening discounts all year long.

The option-income funds (also called Buy/Write or Covered-Call funds) have seen the worst market price performances in 2011 even though their income strategy of selling index or individual call options on their stock portfolios has generally worked well this year and has been the most effective strategy in this volatile up and down market.

On the other hand, most of the global leveraged and dividend harvest fund's NAVs (second table) have underperformed the S&P 500 in 2011, but only a handful are what I would consider to be in a discount/premium downtrend. The strongest funds, both in terms of NAV and price appreciation, have been funds that focus on the domestic utility sector and a couple of these funds have seen significant price increases this year, to a point where their premium prices are what I would consider excessive (red Current Premium/Discount column in table 2).

So what's going on? Is the market trying to look out 6 months and sees a stronger market environment which would favor the leveraged funds over the option-income funds? Maybe. Leveraged funds offer better appreciation potential in strong markets and investors may be positioning more for a risk trade rather than a defensive trade. But over 6 months ago I said that the more defensive option-income strategy would outperform in a more difficult up-and-down market environment, and that's exactly what has happened, though many of the funds that were able to take advantage of this have continued to sell off.

Considering the difficult global market environment in 2011, it may be reassuring to investors that the leveraged global CEFs did not get hit harder than they could have. Much of that reason lies in the performance of their fixed income/bond investments (corporate bonds, preferreds, etc.) which can make up to one-third of the leveraged fund's portfolios. 2011 has generally been a better year for fixed-income/bond sectors than equity sectors and that certainly has been reflected in the CEF universe too.

What to expect in 2012? The onset of a new year often brings rotations in CEFs and those funds that may have been out of favor one year may come into favor the next. I believe that investors should continue to overweight quality option-income funds in case of a continued volatile, up and down market since at some point, their relative undervaluation will be too tempting for longer term institutional holders to ignore.

Most of the option-income funds have much better balanced income to distribution levels now after a series of distribution cuts during the 2009-2010 ramp-up market, so I don't believe distribution cuts should be a worry at this point. Option-income funds generally offer superior yields than leveraged funds and with so many option-income funds at double-digit discounts right now, investors can pick up significant windfall yields as well (see "Current Market Yield" column in table 1).

That being said, it is clear that investors want to reward the risk on trade, and if the markets can get past the global sovereign debt issue, then leveraged funds with global portfolios could significantly outperform the broader markets next year. I will come out with an end-of-year article identifying which funds I like for 2012, based on varying market environments.

Disclosure: I am long EFA, FXI, ETB, ETV, ETW, IGD, EOS, EVT, ETG, and short SPY.