Closed-end funds offer several ways to capture “alpha” or excess return over a benchmark. Unlike open-end mutual funds, closed-end funds issue a fixed number of shares that trade in the secondary market and often trade at a discount or a premium to their net asset value.
There are two main ways to capture “alpha” from closed-end funds:
1) Discount Capture: This occurs when you buy a closed-end fund at a discount which then narrows. (You can also capture alpha when you buy a closed-end fund at a premium which then widens further but this can be risky if the premium goes away).
Here is an example of discount capture. You buy a closed-end fund at a discount of 20%. The net asset value is $100, and you buy the fund for $80. Suppose the overall market goes up 10%, the net asset value also goes up 10%, and the discount narrows from 20% down to 15%.
The new net asset value is now $110, and the new market price at a 15% discount would be 0.85*110= 93.5. You have earned a return of 93.5/80= 16.9%. So the “alpha” earned from discount capture in this example is +6.9%.
2) Dividend Yield Enhancement: With dividend yield enhancement, you are not depending on a change in the discount to net asset value, so this method for capturing “alpha” is available for longer term buy and hold investors.
Suppose you own a closed-end fund which distributes 10% of net asset value each year and sells at a 20% discount. Assume a net asset value of $100 and a market price of $80. The $10 annual distribution is 12.5% of market price, so you are earning an additional 2.5% in yield enhancement alpha because of the discount.
Another metric I like to look at is the adjusted expense ratio which is the dividend yield enhancement alpha subtracted from the expense ratio. In some cases, this results in a negative adjusted expense ratio.
For the hypothetical example given above, assume a fund expense ratio of 1% a year.
- Dividend Yield enhancement alpha= 12.5% * 20%= +2.5%
- Expense Ratio= 1.0%
- Adjusted Expense Ratio= 1.0 – 2.5= -1.5%
I have compiled a list of six equity dividend funds where the sum of the discount and annual distribution rate exceeds 20%. All of the quoted distribution rates benefit from dividend yield enhancement. Two of these funds (ETG, JTA) have negative adjusted expense ratios.
1-Blackrock Strategic Equity Dividend (BDT)
Expense ratio= 0.95%
Annual Distribution Rate (NAV) = 5.71%
Annual Distribution Rate (market price) = 6.63%
Dividend Yield Enhancement alpha= +0.92%
Adjusted Expense Ratio= +0.03%
2-Eaton Vance Tax Advantaged Global Dividend Opportunities (ETO)
Expense Ratio= 1.29%
Annual Distribution Rate (NAV) = 6.97%
Annual Distribution Rate (market price) = 8.24%
Dividend Yield Enhancement alpha= 1.27%
Adjusted Expense Ratio= 0.02%
3-Eaton Vance Tax Advantaged Global Dividend Income (ETG)
Expense Ratio= 1.11%
Annual Distribution Rate (NAV) = 8.82%
Annual Distribution Rate (market price) = 10.07%
Dividend Yield Enhancement= 1.25
Adjusted Expense Ratio= -0.14%
4-Eaton Vance Tax Advantaged Dividend Income (EVT)
Expense Ratio= 1.20%
Annual Distribution Rate (NAV) = 7.68%
Annual Distribution Rate (market price) = 8.84%
Dividend Yield Enhancement alpha= 1.15%
Adjusted Expense Ratio= 0.05%
5-First Trust Active Dividend Income (FAV)
Expense Ratio= 1.67%
Annual Distribution Rate (NAV) = 9.81%
Annual Distribution Rate= 10.98%
Dividend Yield Enhancement alpha= 1.17%
Adjusted Expense Ratio= 0.50%
6-Nuveen Tax Advantaged Total Return (JTA)
Expense Ratio= 1.10%
Annual Distribution Rate (NAV) = 7.91%
Annual Distribution Rate (market price) = 9.21%
Dividend Yield Enhancement alpha= 1.30%
Adjusted Expense Ratio= -0.19%