Equity CEFs: Is This 2011 All Over Again?

by: Douglas Albo

Just when you thought 2012 was going to be a better year for high yielding equity based Closed End Funds (CEFs), along comes another reminder that as quickly as these funds can rise, they can turn back down. After a fast start in 2012 in which many fund's market prices far outperformed their Net Asset Values as well as many of their benchmark indexes, there was a feeling that a rotation from fixed income investments to equity investments was finally going to allow equity CEFs to have a good year.

Going back to the end of 2011, most funds were coming off heavy tax-loss selling which had brought most equity CEF market prices down to their widest discounts and lowest valuations since the bear market ended in early 2009. Just to remind investors, CEFs have two prices they can follow. One is the fund's Net Asset Value, which is the true value of the fund and only includes the fund's investments minus its liabilities. The other is the fund's market price, which is what most investors follow and can be influenced more by market volatility and investor emotions. As a result, CEF market prices can often be more volatile than their NAVs and exhibit whip saw action in which their market prices can quickly make up and overtake the market direction both to the upside as well as the downside.

Since the beginning of May, we've seen another sharp pullback for the markets and equity CEFs have been picking up steam to the downside as well. So far this has been fairly orderly but my concern will be if confidence starts to wane and less liquid investments like CEFs overshoot to the downside. With that in mind, I thought it might be worthwhile to look at the damage that has already been done and perhaps prepare for worsening conditions.

The following tables sorts the market price performances of most of the equity CEFs since this mini sell-off began May 1st. The funds are grouped by the most widely recognized CEF fund families. The funds are color coded by income strategy in which option-income funds are shown in blue, leveraged funds in orange and dividend-harvest funds in olive. The first table begins with funds from BlackRock (NYSE:BLK) and ING. I have also included broad market ETF performances at the bottom of each table for comparison. All performances are from May 1st - May 18th and includes any distributions that occurred during the period as well.

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Both the BlackRock and ING equity CEFs have suffered the biggest hits of their equity CEF funds since May began partly due to many of these funds having greater overseas exposure than most other family sponsors and partly because of distribution cuts for many of these funds over the past 6-months, ING in December and a couple of the BlackRock funds earlier this year.

Some of the BlackRock funds are back to their discount lows of 2011 and I believe are nearing washout levels, as long as the global markets don't drop precipitously from here. What's happening to the BlackRock International Growth and Income Trust (NYSE:BGY) and the BlackRock Global Opportunities Equity Trust (NYSE:BOE) is not unlike what happened to the BlackRock Enhanced Capital and Income fund (NYSE:CII) last year when CII cut its distribution in June of 2011 and investors headed for the exits, especially in August when the global market sell-off accelerated. That turned out to be a good buying opportunity for CII and that may be the case for BGY and BOE, which both saw very large and long overdue distribution cuts earlier this year and have been pummeled ever since. Still, as global funds, they will be more vulnerable to the overseas markets than CII, which is 95% US based large cap stocks. The least risky of the BlackRock funds and probably the best value is the BlackRock Enhanced Dividend Achievers Trust (NYSE:BDJ) which has a mostly US based stock portfolio like CII and is matching its widest discount at -12% to -13% since March of 2009.

Most of the ING funds are relatively overpriced in my opinion and I believe these funds have the most downside risk in a continued global market fallout. However, one fund that I had been negative on for years when it traded at a premium is now what I would consider attractive.

The ING Risk Managed Natural Resources fund (NYSE:IRR) is in fact, one of the most defensive funds you can buy. Anything natural resource or commodity related is getting hit especially hard right now and IRR includes mostly oil and oil service sector stocks in its portfolio. However, what most investors don't realize is that IRR hedges a large portion of its natural resource stock portfolio by buying put options (hence, the "Risk Managed" in its name). As a result, IRR's NAV hasn't and won't get hit very hard even in a continued sell-off of oil and oil related stocks. That is shown above in IRR's relative NAV outperformance so far in May.

I first wrote about IRR back on January 26, 2011 in one of my first articles on Seeking Alpha which you can read here, I argued that IRR, because of its sell call option/buy put option spread strategy would not participate in any strong move to the upside in the oil or oil related sectors. At the time, IRR was trading at a 5.5% premium price which was at the high end of its premium/discount range. By the end of 2011 however, IRR was trading at a -11% discount as it too got caught up in the equity CEF exodus at the end of 2011. Here is IRR's 3-year Premium/Discount graph in which IRR's valuation finally took a steep drop in 2011.

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I don't necessarily like the sell call option/buy put option spread strategy in CEFs, however there is little doubt that the NAV prices of these funds will hold up far better in a market rout than their market prices. At some point, these funds become good buys as investors will sell even the most defensive "Risk-Managed" funds without realizing that a market sell-off is exactly what these funds are designed for. At a -7% discount and a 12% market yield, IRR is the most attractive of the ING funds in my opinion but I would only look at IRR as a trade, since longer term, the fund has not shown that it can grow its NAV in any market environment and ING would be wise to drop the buy put option spread component altogether.

Speaking of defensive funds, the next family of funds to be sorted by their May market price performances are from Eaton Vance (NYSE:EV) and Nuveen. I grouped these two fund families together because not only do they offer some of the most defensive equity CEFs you can find, but they also offer the most US stock based funds as well.

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The most defensive of the Eaton Vance funds are the Tax-Managed Buy/Write Income fund (NYSE:ETB) and the Tax-Managed Buy/Write Opportunities fund (NYSE:ETV), selling 95% index option coverage on their large cap US based stock portfolios. Both of these funds are frankly, must owns for any long term investor in equity CEFs, particularly in market sell-off periods. Both ETB and ETV's NAVs have SOLIDLY outperformed the S&P 500 since their inceptions and contrary to popular belief, the high return of capital (NYSE:ROC) in their distributions makes them even more attractive than many other funds. Remember, "Tax-Managed" for these funds means the managers try to maximize losses where they can and minimize capital gains so that distributions are mostly ROC.

The Eaton Vance Risk-Managed Diversified Equity Income fund (NYSE:ETJ) may appear to be the most attractive Eaton Vance fund based on its May NAV performance and one of the widest discounts of all CEFs at -16.9%, but I would discourage investors from buying ETJ other than for a trade. ETJ also uses a sell call/buy put option spread strategy similar to IRR above and thus, ETJ's NAV will hold up better in a market sell-off. The problem longer term is that Eaton Vance has not shown the ability to grow this fund's NAV in ANY market environment and the fund continues to lose value both on an NAV and market price basis. I have encouraged Eaton Vance over the years to just drop the buy put option component which has just been a huge expense burden to the fund, but to no avail. I believe ETJ has dragged down the valuations of the rest of the Eaton Vance option-income fund's with it, many of which are otherwise excellent funds.

For the most defensive funds you can find that don't use a spread put option strategy, the Nuveen fund's Equity Premium Opportunity fund (JSN), Equity Premium Advantage fund (JLA) and Equity Premium Income fund (JPZ) all sell 100% index call options IN-THE-MONEY, to provide superior downside protection, especially when new monthly option rotations begin (June expirations begin next week). I first wrote about these funds back on June 9, 2011 and all of these fund's NAVs have significantly outperformed their benchmarks since then. You can learn more about the advantages of these funds during difficult market periods in my article here.

Finally, for a leveraged fund that is more bull market focused, Nuveen's Tax-Advantaged Dividend Growth fund (NYSE:JTD) has been exceptionally well managed over the years and is another long term hold for any equity CEF investor in my opinion.

Earlier this year, I urged investors to overweight the leveraged funds over the option-income funds in anticipation of a better equity market environment for 2012. The sell-off so far in May has frankly, unnerved my more bullish outlook and I should make clear that leveraged funds have more downside exposure than option-income funds if the global markets continue their sell-off, but should the markets recover, leveraged funds offer the best appreciation potential. The following table looks at two fund families that focus mostly on leveraged funds, Gabelli and Calamos.

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My favorite of the Gabelli funds is the Healthcare and WellnessRx Trust (NYSE:GRX). GRX is a very small fund at only $105 million in assets that has the potential to make large moves. GRX's NAV performance YTD is up 9.9%, far outperforming any other equity fund I follow. What's also impressive about GRX is that historically, it is even more defensive than the Gabelli Utility Trust (NYSE:GUT), a fund which trades at a 50% premium compared to GRX's -13.9% discount. GRX just instituted a very conservative $0.10/share per quarter regular distribution beginning in June, which I believe could see upward revisions if GRX continues to have superior NAV performance.

The Calamos funds have also had a relatively good 2012 even after the pullback of the last 2 weeks. Both the Calamos Global Dynamic Income fund (NASDAQ:CHW) and the Strategic Total Return fund (NASDAQ:CSQ) saw increases in their monthly distributions in February and both funds have been able to substantially reduce their wide discounts from 2011. I like the Calamos funds but investors need to realize these funds have come a long ways since their lows in 2011 and a continued market sell-off could make these funds more vulnerable.

Other fund families that offer leveraged equity CEFs are Lazard and Clough but in the interest of time and space, I will not be including their performance figures.

The final two fund families I will show are Allianz/PIMCO and the Alpine dividend-harvest funds. Most of these funds are not attractive at all in my analysis but that doesn't mean you won't find investors who will support these funds.

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Disclosure: I am long ETB, ETV, GRX, GDV, BGY, JTD, JLA, CHW, CSQ.