In early 2011, I wrote an article titled "CEFs: Follow The NAV" in which I advised income investors in high-yielding equity-based Closed-End funds (CEFs) that if they wanted to find the best funds to invest in, they should pay close attention to the direction of a fund's Net Asset Value (NAV).
Unfortunately in 2011, following the NAV may NOT have led you to the best performing funds on a market price basis as many funds with outperforming NAVs suffered underperforming market prices. Quite simply, 2011 turned out to be a horrible year for most equity CEFs and many finished the year at some of the widest discount levels since the bear market ended in early 2009. In particular, 2011 was not kind to high yielding funds which utilize an option-income strategy to generate income which they pass on to investors in the form of high distributions and yields. This was surprising since after two years in which the option-income funds' NAVs underperformed in 2009 and 2010, 2011 turned out to be an excellent year for the option-income strategy. A more volatile and trendless market fit well into their strategy of selling index or individual stock options against their stock portfolios. Unfortunately, this NAV outperformance did not translate into better market price performances and many funds from Eaton Vance, BlackRock, ING and Nuveen, all of whom sponsor the bulk of the option-income funds, saw a forgettable year.
Part of the reason may be a hangover from distribution cuts that many of the option-income funds saw in 2010 and even 2011 due to their NAV underperformance in 2009 and 2010 and part of it may be just technical selling that made their market price graphs look alot worse than their total returns (i.e. including distributions). Each distribution brings down the market price and NAV accordingly and with option-income funds having some of the highest distribution yields of all CEF's, their market price graphs can look technically weak even if the funds are doing well on a total return basis. If 2012 turns out to be another volatile and trendless year for stock prices, then the option-income strategy should perform well again on an NAV basis but as we've seen in 2011, that doesn't necessarily have to translate to better market prices.
So in a year in which many investors and analysts got it wrong, and I certainly put myself in that category since I recommended many of the option-income funds that suffered underperforming market prices even with outperforming NAVs, I also made some individual Buy and Sell recommendations from my February 21, 2011 article that I would like to go over. First though, let me show readers the final 2011 NAV and market price performances for all the high yielding equity based CEFs that I follow, since I will be referring back to these tables.
The following two tables include the majority of high-yielding (7% or higher) equity based (i.e. at least 2/3 stock portfolios) CEFs sorted by their income strategy. Table 1 includes funds which use an option-income (also called buy/write or covered-call option) strategy and Table 2 includes funds which use a leveraged and dividend harvest strategy. The funds are further sorted by 2011 NAV performance in which the best to worst performers are listed from top to bottom. Funds which outperformed the S&P 500, as represented by the SPDR S&P 500 ETF (SPY) are shown in green and funds which underperformed are shown in red. Though the S&P 500 would not be the benchmark for all funds, particularly the global funds, I wanted to provide a widely recognized and diversified index for comparison. Note: NAV and Market Price performances includes all distributions added back but not re-invested, including the S&P 500. Though most quoted news sources have the S&P 500 down for 2011, in my tables the S&P 500 was actually up 2.1% when dividends are added back. In addition, "Red flags" for funds with high premium valuations, high expense ratios or high NAV yields are also highlighted in red.
Click tables to enlarge
I will now go back to my Buys and Sells from the article dated February 21st, 2011 to review how I did. You can refer back to the tables to see more detailed information on each fund. Note: I did not start writing articles for Seeking Alpha until later in January so that is why I didn't have a beginning of the year selection list.
Buys from February 21, 2011
- ETW and ETV (Table 1) each had excellent NAV performance for 2011 though their market price performances did not perform as well as I would have expected with that outperformance. Both are very defensive option-income funds, selling index options on roughly 94% of the notional value of their large cap stock portfolios. ETW is also a global fund so even though it slightly underperformed the S&P 500 with dividends, it still outperformed its benchmarks which includes a combination of the S&P 500, NASDAQ and the FTSE Eurotop 100 Index (top 100 blue chip stocks in Europe).
- DPO (Table 1) had the best NAV performance of all option-income funds for 2011 and had positive 7.1% market price performance as well, which was not easy to do for an equity CEF in 2011. DPO owns a slightly leveraged portfolio of the 30 Dow Jones Industrial Average component stocks which explains its strong NAV and market price performance. Surprisingly, DPO had two slight distribution reductions during 2011 as Nuveen, which is one of the most conservative fund families around, chose to emphasize NAV growth over high yield by adjusting downward the quarterly distribution. Nuveen did this for most of its option-income funds even if the funds had some of the strongest performances in 2011.
- IDE (Table 1) is also an option-income fund that focuses on global infrastructure, industrials and materials stocks. If IDE's portfolio was more utility sector focused as opposed to construction & commodity sector focused, it would have had a much better 2011 but with a low option coverage of only 34% and a stock portfolio that is 55% overseas, IDE was susceptible to the underperformance of global stocks in underperforming sectors and saw a negative NAV return of -8.9% for 2011. On a market price basis, IDE saw a -12.7% market price total return for 2011 and a -15.9% market price total return from when I wrote the article.
- ETG and ETO (Table 2) are leveraged funds that include a global portfolio of stocks and domestic fixed-income preferred securities. Considering their global stock portfolios and roughly 27% leverage, ETG and ETO performed well from an NAV perspective, though like the Eaton Vance option-income funds, they saw their discounts widen. This was particularly towards the end of the year, although ETG did actually rise to a premium market price for a short while in September. Though ETG's NAV performance was breakeven for 2011, its market price performance eventually succumbed to selling and finished the year down a modest -4.6% on a total return basis. ETO, on the other hand, suffered much worse in the market price category even though its NAV was down -4.7% on the year. ETO's market price was down -15.8% since I wrote the article though a better -10.9% for the year as a whole. This may have been due to disappointment over a non-dividend increase which I thought the fund deserved earlier in 2011.
Sells from February 21, 2011
- IRR (Table 1) is an option-income fund which includes mostly commodity stocks (energy, materials, metals) in its stock portfolio. IRR is a bit unusual among option-income funds in that it buys put options against its portfolio as well as selling call options. This extremely defensive (and very expensive) collar option strategy I argued would NOT take advantage of any up move in commodity stocks and thus the fund did not deserve a 6.7% premium pricing it had at the time back in late February. I even wrote an article a month earlier on IRR pointing out my concerns. As it turned out, the commodity sector had mixed performances in 2011 and even though IRR's NAV dropped only -4.3% on the year, its market price dropped significantly worse. Since I wrote the article, IRR has gone from a 6.7% premium to a -10.2% discount, for a total market price performance of -21.2%.
- AGD (Table 2) quite simply had the worst NAV performance of all equity CEFs I follow, down -17.1% for 2011. AGD's market price was even worse, going from a +12.4% premium when I wrote the article to a -1.3% discount for a total negative return of -28.3%.
Overall, I would give myself a B grade. 2011 was not a good year for equity CEFs in general and it was difficult to find one that even had positive market price performance outside of the utility focused funds. I was correct in most cases as to the direction of the NAV, picking both the strongest performer of the option-income funds (DPO) and the weakest performer of all funds (AGD), however I did not anticipate the strength in the utility sector which benefited the top performing equity CEFs such as HTD, DNP and GUT, all of which have overweightings in utility stocks. Nor did I anticipate the extreme weakness in overseas markets which hurt most of the global funds. But I generally don't try and predict market direction or top performing sectors, preferring to pick the most undervalued funds which I feel are in the sweet spot of their income strategy but yet may be underappreciated by investors.
2011 proved to be a year in which the NAV didn't seem to play a huge role in a fund's performance and most funds' market prices sold off going into the end of the year regardless of NAV performance. Though CEF market prices are often dictated by investors' emotions and technical trading patterns, their NAVs are only subject to the performance of their underlying portfolios and in my experience, the market price will ultimately follow the NAV up or down. I am sticking with that theme for 2012 so with that in mind, let's take a look at my 2012 predictions in Part II of my Best Equity CEFs for 2012.
Disclosure: I am long ETW, ETV, ETO, ETG, HTD.