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Income investors seeking aggressive distributions should take a closer look at closed end mutual funds. There is no shortage of these often overlooked investment vehicles, but they are not all created equal. There are potential pitfalls that can result from chasing the industry trap of unsustainable high distribution yields.

To help standout in a sea of peers many of these funds attempt to draw in customers by offering compelling distributions and return on capital. To be able to do this many of these funds use some form of leverage requiring costly active management.

If leverage is haphazardly used it can have significant consequences and can expose the fund and its share price to extreme risk. Changes in the interest rates and market conditions will make highly leveraged funds even more volatile.

When it comes to these closed end mutual funds an investor needs to make sure that the source of the yield is derived from ordinary income or capital gains as that suggests management is successfully running the fund.

Also beware that many of these funds use a yield policy based on their estimate of future investment income. Any potential future deficit in this may be solved by the fund using return of capital to make up the difference between their estimate and actual investment income.

What this means is that the fund is using return of capital disguised as investment income to the investor. This strategy is not in the income investor's best interest as the fund is taking advantage of the investor by decreasing the actual value of their investment.

Since my last buying endeavor of these assets at the end of 2011 sale, I have been waiting for the right situation to add to my positions of several of these attractive high yielding funds at more compelling valuations. Hopefully, this correction will continue to provide that opportunity.

Today I will look at two solid names and one wildcard. They include GAMCO Global Gold, Natural Resources & Income Trust by Gabelli (GGN), Eaton Vance Tax-Advantaged Global Dividend Income Fund (ETG), and Eaton Vance Risk-Managed Diversified Fund (ETJ). I would be adding to my position in GGN and ETG. I currently do not own any position in ETJ.

I like to use the following screening criteria to help combat transparency issues specifically related to this type of asset class.

  1. Do they have a stable or increasing payout history?
  2. Is this payout sustainable?
  3. What are their long-term growth prospects?
  4. What does their portfolio consist of?
  5. What is the current price relative to Net Asset Value.
  6. What is their current method for generating an income stream via options or other strategy employed. This is important for yield coverage.
  7. What types of hedging are used?
  8. How are they leveraged?
  9. Do I trust the company backing this fund?
  10. Do I agree with management's investing philosophy and what are their fees? Higher fees are often associated with higher leveraged more actively managed funds.

GGN

In my opinion there are really three things in life that are certain: Death, taxes, and debt increases. The debt clock continues to tick upward making gold and other precious metals a tangible asset unlike fiat paper currency. As the monetary supply around the world continues to be devalued by excess easing, look for gold related assets such as GGN to outperform. This particular play on gold, precious metals, commodities, and energy offers an incredible yield of over 10% paid monthly. The payout history is very consistent and stable. GGN also offers a dividend reinvestment plan (DRIP) which allows an investor to purchase shares at a discount to market price under certain conditions. As of the end of last year the portfolio of GGN included 45% in stocks and fixed income securities of gold and other precious metals mining companies, 43% in stocks and fixed income securities of energy companies, and 12% in stocks and fixed income securities of base metal and other commodity companies. GGN utilizes a covered call strategy on the majority of its holdings. This strategy generally consists of writing "out of the money call options" for each of the names owned in the portfolio. The premiums that are collected contribute to the monthly distributions made by GGN. The current net asset value of GGN is 14.04. It is currently trading at around 15.60. This represents an 11% premium over net asset value. GGN regularly trades at a premium to NAV. I am alright with buying around 5% over NAV. If they can keep leverage down I am comfortable with holding this CEF for the foreseeable future. During the liquidity crisis they suffered badly because of the effects of over-leveraging.

ETG

This is another fund I think can outperform. The primary goal of the fund is simple: distribute a high level of dividend income that qualifies for the reduced tax rate. Therefore, ETG invests 80% of its assets in dividend-paying common and preferred stock that is eligible to pay qualified dividends, which are taxed at a lower rate. It also utilizes a dividend-capture strategy on a portion of the portfolio. The fund may additionally invest in Eaton Vance Cash Reserves Fund, LLC (Cash Reserves Fund), an affiliated investment company managed by Eaton Vance Management (EVM). EVM is the Fund's investment advisor. ETG is currently trading at 13.99 with a current discount to NAV of 4.2%. ETG has a stable and consistent distribution yield of 8.79% paid on a monthly basis. Since January ETG has a market return, not including distributions, of around 10%.

ETJ

This is the wildcard. I do not currently own this name but have been keeping an eye on it for a while now. It continues to get hammered with seemingly no change in strategy from management. This fund is now fast approaching its 52 week low. It sports an aggressive yield of 12.22% annually. An alarming fact worth mentioning is the quarterly distribution was cut in 2010 from 45c to 32c in 2011. It has a market cap of around $760 million. The strategy of ETJ is basically generating income through options, which includes writing call options on its portfolio of mostly quality equities like AAPL and GOOG and buying and selling put options. Unfortunately this has restrained the fund's long-term performance. While the fund has had success in limiting volatility, it's had difficulty meeting its distribution payout without the help of destructive return of capital.

ETJ interests me because it is one of only two managed high yielding equity based funds that buy index put options on 100% value on their portfolios. Similar funds only provide a percentage of coverage, however most of them only sell call options on their stock portfolio to generate income. I also like it because it is almost 100% equity based with minimal leverage.


(Click to enlarge)

Of particular interest in the above graph is the widening distance between share price and NAV. I believe this widening is due to recent abandonment of the fund. ETJ is currently trading at around 10.45. It's current NAV is 12.47. This represents an enormous discount to NAV of almost 20%. Maybe management has fallen asleep at the wheel?

Source: 3 High-Yielding CEFs To Watch On Continued Market Weakness