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About a year ago I suggested that income investors in high yielding equity closed-end funds (CEFs) should start looking at funds which utilized an option-income strategy to generate income for their large distributions as a two-year bull run in the market was likely to give way to a more sideways market period and play more into the hands of funds which utilized an option-income strategy as opposed to other income strategies. I maintained that position through all of 2011 and this turned out to be exactly the correct position even if the market prices of most option-income funds did not perform well in 2011 along with the vast majority of equity CEFs.

Option-Income Funds vs. Leveraged Funds

Just to give readers a quick refresher course, option-income funds work best in volatile and trendless up and down markets in which their covered-call option contracts they sell against their U.S. or global stock portfolios are more likely to go down in value or expire worthless. 2011 turned out to be just such a market and many option-income funds' NAVs (not necessarily their market prices) were able to outperform their benchmarks. Leveraged funds, on the other hand, work best in up markets where their leveraged portfolios of stocks and/or bonds just increase the amount of income from their portfolios as well as appreciation of their portfolios. Leveraged funds are also much more likely to raise distributions in an up market period as well.

2012 has started off with a bang and I believe that leveraged funds will continue to outperform the option-income funds for most of 2012. This is not to say that option income funds won't do well either, but for real appreciation potential, the leveraged funds offer more upside. However, leveraged funds are also more risky and investors would be wise to pick their spots and wait for a market pullback to initiate or add to positions. Once that occurs, here are the leveraged funds I would recommend to investors.

Leveraged Equity Funds to Buy

Last week I wrote about the Gabelli funds and I'd like to expand a bit more on the Gabelli Equity Trust fund (NYSE:GAB) and why I like this fund. GAB is a 23% leveraged, pure equity fund with most of its large cap holdings based in the U.S., around 80%. In my article from last week, which you can read here, here. I stressed that between the Gabelli name and a strong equity research desk, a leveraged fund like GAB which lists capital appreciation first and income second, could be a strong beneficiary. Even with income as a secondary investment objective, GAB raised its distribution twice in 2011 due to a 10% NAV distribution policy and offers an incredible 11.8% current market yield, one of the highest among leveraged funds. With a NAV already up 8.3% YTD through February 10th, GAB could have significant total return for 2012.

GAB is one of those CEFs that generally trades close to par with its NAV, usually between a -5% discount to a 5% premium, though it did get up to a 20% premium in June of 2009. Currently, GAB is at a -3.4% discount to NAV which is not particularly wide but is still toward the lower end of its range. One of the reasons why GAB rarely ventures below a -5% discount is because Gabelli has shown the ability to weather difficult periods even with a leveraged portfolio. The following table shows GAB's NAV quarterly performance vs. the S&P 500 from 2006 including all dividends and distributions added back, i.e. not reinvested. This is a much more accurate picture comparing GAB's NAV against the S&P 500, as shown by the SPDR S&P 500 Trust ETF (ticker SPY) because most quoted S&P 500 returns do NOT include any dividends. Green is for up quarter over quarter periods while red is for down periods.

Click to enlarge

Though GAB's NAV performance is not that significantly above the S&P 500 from the 2006 starting point, once you have this longer term table then you can compare funds from different starting points. I do this for a lot of CEFs, comparing NAV total return performance with their benchmarks like the S&P 500 and even comparing with other CEFs, so I know which funds have historically done better than others and the results can be pretty eye-opening.

The next two tables compare GAB with the S&P 500 from the top of the market (third quarter 2007) and from the bottom of the market (first quarter 2009). Though one would expect a leveraged fund to far underperform from the top of the market, GAB's NAV held up well down only -11.7% on a total return basis compared to the S&P 500 down -5%. However, it's during an up market period that GAB's leverage with quality stock holdings really shine. From the market lows of March, 2009, GAB's NAV is up 124% compared to the S&P 500, up 77.1%, again on a total return basis. Note: This does not compare GAB's market price performance which can have even greater appreciation or depreciation potential as reflected in the fund's premium or discount price.

Quarterly performance from market high, third quarter 2007.

Quarterly performance from market low, 1st quarter 2009.

The bottom line is that GAB has one of the best up market performance periods I have found among leveraged funds while being very forgiving in a down market as well.

Two Calamos CEFs Raising Distributions

Two more leveraged CEFs I am recommending are the Calamos Global Dynamic Income fund (NASDAQ:CHW) and the Calamos Strategic Total Return fund (NASDAQ:CSQ). One reason why I like these funds is that on January 31st of this year, Calamos raised the distribution on CHW and CSQ a hefty 24% and 33%, respectively. Distribution raises are always a positive step for CEFs and both funds responded nicely. But a second reason why I like these two funds is because of their low valuations. Just at the end of 2011, both CHW and CSQ were trading at over -15% discounts. The dividend increases announced just a couple weeks ago have helped reduce those discounts down to the current -10.9% for CHW and -10.1% for CSQ but those discounts are still quite wide and I believe the funds have further upside to go.

Both funds are a little different than GAB in that they have corporate and convertible bond exposure in their portfolios, around 35% to 40%, which is actually more common among leveraged equity CEFs than a pure equity portfolio like GAB. A balanced portfolio approach means the funds are managed for income first and capital appreciation second. But in reality, these funds have a lot of upside potential as well due to their higher use of leverage, around 27%. CHW is more global than CSQ and for me, makes a better fit with GAB which is more U.S. based, but I like both funds.

Calamos may not be a well known name among mutual fund or closed-end fund sponsors but I don't think you'll find more up-to-date information and disclosures on their funds than from Calamos. I would urge income investors to go to the website (here) and review their closed-end fund offerings.

Getting back to the quarterly performance tables, what I did this time was compare CHW with another fund that I wrote about just last week, the Alpine Global Dynamic Dividend Income Fund (NYSE:AGD). Both funds are global and pay monthly distributions (CHW at about 8.9% and AGD at 11.6%) but I argued that AGD has been a disaster for investors with an income strategy that has essentially failed to provide any NAV growth over the years.

The following two tables compare quarterly NAV performances of these two funds from the market high starting in the third quarter of 2007 (Table 1) and from the market low starting in the first quarter of 2009 (Table 2). Keep in mind as you go over these two tables that CHW currently trades at a -10.9% discount to its NAV while AGD trades at a 7.3% premium.

Table 1 - From Market High

Table 2 - From Market Low

This is what I'm talking about when I say these comparisons can reveal eye-opening results. Not only can you find undervalued funds like CHW trading at a -10.9% discount and which just raised its distribution but you can also uncover overpriced and overpaying funds like AGD that may have to have another distribution cut based on its NAV erosion over the years. In any event, CHW's NAV has far outperformed AGD in both an up market and a down market period and yet its CHW that trades at a -10.9% market price discount compared to AGD at a +7.3% premium. AGD's NAV is actually lower today than it was at around the market lows at the end of March of 2009. Think about that for a second. Its almost comical how the market values these funds at times but this is where the opportunity arises for investors.

Anyway, this article is not about overvalued funds but rather undervalued leveraged funds that can take advantage of a continued up market environment. GAB, CHW and CSQ are three such funds and I would urge income investors who are also looking for growth opportunities to consider these funds on any market pullback.

Source: Which Leveraged Equity CEFs To Buy On A Market Pullback

Additional disclosure: Short AGD, long AOD.