Before I begin my analysis of the Spectrum Asset Management preferred closed end funds (under the Nuveen umbrella), I would like to restate what my objective is with this series of analyses.
At one point in my career, I worked for an investment consulting firm, where I was the Director of Fixed Income Research. Essentially, what I was responsible for was analyzing managers and recommending managers for our clients' (pensions, endowments, foundations...) fixed income mandates. The analysis and recommendations were based on:
Manager returns, and
Fund/portfolio client fit
This is what I planned for the series: I am going to review three managers' preferred closed end fund complexes (one manager per article) and recommend one fund per manager. The fourth complex will be recommendations from readers/commentators (I will pick the four most recommended/popular funds picked by the readers). The fifth article in the series will be the showdown between the top four picks. Essentially, I am trying to bring institutional manager selection to Seeking Alpha readers. Hopefully this will be very interactive. All data used in this report is from company reports and filings, CEFA and morningstar.
Spectrum Asset Management is a world-leading manager of preferred securities, with over US$13.4 billion in assets under management as of December 31, 2011. Spectrum was founded in 1987 and has been a wholly owned and independently run affiliate of Principal Global Investors, a member of the Principal Financial Group since 2001. Spectrum has a team of seventeen dedicated investment professionals and is based in Stamford, Connecticut.
Spectrum manages portfolios of preferred securities for an international universe of corporate, pension fund, insurance and endowment clients, open-end and closed-end mutual funds domiciled in the United States, Ireland and Japan, and separately managed account programs for high net worth individual investors sponsored by a variety of broker-dealers.
Spectrum has produced a record of strong performance by consistently implementing its fundamental credit-based investment philosophy, leveraging its expertise in capital structure analysis and employing and retaining its experienced team of investment professionals. (from the manager's website here: Spectrum Asset Management)
The funds managed by Spectrum that will be analyzed are:
Nuveen Quality Preferred Income Fund (JTP)
Nuveen Quality Preferred Income Fund 2 (JPS)
Nuveen Quality Preferred Income Fund 3 (JHP)
The funds objectives are stated as (from funds annual report (N-CSR)):
The investment objective of each Fund is to earn high current income consistent with capital preservation. Each Fund's secondary objective is to enhance portfolio value. Under normal market conditions, the Funds seek to invest at least 80% of their net assets in preferred securities and up to 20% in debt securities, including convertible debt securities and convertible preferred securities.
Our basic strategy is to stay relatively balanced between the individual investor-oriented $25 par preferred securities often traded on securities exchanges and the institutional investor-oriented $1000 par preferred securities traded over-the-counter in the capital markets. Both types of securities offer unique short term capital performance differences, which together with the broad diversification benefits of the combined universe, help to produce potentially attractive risk-adjusted rates of return.
We keep a risk-averse posture toward security structure. This is an important core aspect of our strategy, which, over the long-term, seeks to preserve capital and provide attractive income.
We also maintain approximately a 60% weighting to U.S. names and a 40% weighting to foreign names as part of the basic strategy that keeps all the Funds in a neutral position relative to the benchmark.
An overview of the funds is as follows: (Click to enlarge)
Manager style in a preferred CEF context can be somewhat determined by portfolio concentration, sector allocation and portfolio turnover.
Portfolio concentration - Ideally, if an investor wants a stable return (payout) portfolio, the manager should not have overly concentrated positions (or sectors to be addressed next). A review of the top ten holdings should give us a feel for the concentration of the portfolio. What we are going to look for is positions greater than 5-10% and significant sector concentration within the top ten holdings. Let's take a look: (Click to enlarge)
Reviewing Spectrum's various portfolios does not reveal overly concentrated positions (highest is 4.64%) and the top ten holding max at 25.7%. This should help manage volatility and swings in the portfolios as there is not a significantly concentrated portfolio. One other thing to notice is how the top ten holdings across portfolios do not have much of an overlap, which is somewhat peculiar as it is the same management team across the portfolios.
One of the things I found interesting in the portfolios was shares in both Flaherty and Hancock CEFs, not a huge exposure, just interesting.
Sector allocation - Part of a manager's style can be determined by their sector/industry distribution. If a fund/portfolio is too focused in any one sector, the manager is making a "bet" on the sector and returns can be volatile. For our purpose, we desire a portfolio that is diversified among sectors and has stable constituents as well as higher beta constituents. Let's have a look:
A Review of Spectrum's portfolio allocation shows that the manager has kept allocations constant over the last two years and nothing really jumps out and grabs me as an outsized "bet" on any one sector. Due to the similarity between funds and the similarity of changes to industry allocation from 2010 to 2011, I do not see that any fund is either advantaged or disadvantaged due to their industry allocation.
Portfolio turnover - A manager's style can often be viewed as a "closet benchmarker" or an "active manager". A benchmarker will often "set it and forget it" and have very low portfolio turnover, whereas an active manager will have a greater turnover as they attempt to optimize their portfolio. Let's see where Spectrum falls: (Click to enlarge)
While Spectrum's turnover dropped substantially (to say the least) during 2011, I would view it as a moderately active manager. I say moderately, as turnover is lower than some, but above a "closet benchmark" portfolio (this view might change if turnover and portfolio optimization does not increase from 2011 levels).
Ratings - Often a manager's style can be reflected in the portfolios' ratings distribution. For a "current yield" based portfolio, a large concentration in high yield can reflect higher risk based yield and hint to future volatility and difficulty maintaining current distribution rates. A review of Spectrum's portfolios does not raise this concern:
The funds have a somewhat consistent ratings distribution, with each one having its own nuances (JTP and its not rated allocation, JPS and its BBB overweight and JHP with its higher ratings profile). From this respect, JPS has, in my opinion, the advantage due to its more balanced approach of all of them.
Returns are the easiest aspect of our analysis as they are the result of all the factors analyzed. (Click to enlarge)
As we have seen with other preferred CEFs (see Part I), volatility is not limited to common equity. While year-to-date returns have been decent, the five year returns (all negative) are somewhat disconcerting. Returns to the funds are somewhat consistent, but in this respect JPS has the advantage of having the best three and five year returns, outperformed in the best year and only slightly underperformed in the worst year.
Fund/portfolio client fit:
This analysis was done with a client interested in high current income with capital preservation in mind. All the funds reviewed would be consistent with this mandate, but an emphasis has to be placed on those funds trading closer to their historical premium (discount) as "premium evaporation" could have a significant effect on capital preservation. Normally, I would also place an emphasis on those funds with the greatest tax advantaged component of the distribution (the QDI or qualified dividend income component for individuals and DRD or dividend received deduction for corporations). Due to the sunsetting of this tax provision at the end of this year (as it currently stands), I have looked at it (see below) but did not place an undue amount of emphasis on it.
All of the Spectrum funds have a decent tax advantaged situation until the QDI provision sunsets at the end of this year. As a result of their tax advantaged similarity, no one fund is either advantaged or disadvantaged from this standpoint.
When I review all the information presented above, I arrive at the following conclusion: The funds are somewhat homogeneous and have similar attributes, the manager's style from a sector basis is consistent among funds although the top holdings of the various funds vary and have little overlap. Liquidity is available across funds due to their relative size and the expense ratios are pretty close (7bps from high to low), so my choice will primarily be a factor of historical returns, distribution yield and premium (discount).
As a result of the above analysis, my top pick from the Spectrum preferred CEF complex is Nuveen Quality Preferred Income Fund 2 (JPS). The fund has the highest distribution rate and the highest returns over YTD, 3yrs and 5yrs. The fund is consistent in its allocation within the top ten positions, the sector allocation and the ratings allocation and is the closest to its five year discount average.
Disclosure: I am long JPS.