Equity CEFs: Which Funds Have A Real Return Of Capital? (Part II)

Includes: AGD, AOD, ETY, EXG
by: Douglas Albo

Back on January 13, 2011, I wrote an article called "Which Funds Have a Real Return of Capital," which compared four high-yielding global stock Closed-End funds (CEFs) and how investors had misjudged which funds were really just giving back an investor's capital. The article was actually re-titled by Seeking Alpha to "Which Dividend Harvest CEFs Have a Real Return of Capital."

I argued that the Alpine Global Dynamic Dividend fund (NYSE:AGD) and the Alpine Total Dynamic Dividend fund (NYSE:AOD), funds that were trading at significantly higher valuation levels (as measured by the fund's premium/discounts) were much more guilty of "returning capital" to investors it seemed than the two other funds in the article, the Eaton Vance Tax-Managed Diversified Equity Income fund (NYSE:ETY) and the Eaton Vance Tax-Managed Global Diversified Income fund (NYSE:EXG), funds that on the surface, included a lot of "Return of Capital" in their distributions but in actuality had done a much better job of preserving Net Asset Value (NAV) and thus had significantly outperformed the two higher-valued funds.

In other words, based on their historical total return NAV performances, the two funds at the lowest valuations, ETY and EXG, had trounced the funds at the highest valuations, AGD and AOD. What made the argument even more compelling was that all 4 global stock funds started with $19 inception NAVs and each with similar inception yields. In addition, all 4 funds went public within 7 months of each other in mid 2006 to early 2007, which made them excellent total return comparisons with the financial crisis looming later in 2007 and with a market recovery beginning in early 2009. The big difference in the funds was how they derived income to pay for their large distributions and yields. AGD and AOD used a dividend harvest strategy while ETY and EXG used an option-income strategy. Here is the table I used in the January 13, 2011 article (updated with red for negative total returns and green for positive).

At the time, I argued that investors were completely getting it wrong as to which income strategy was more effective at generating income while maintaining NAV value, hence why the total return NAV performances of ETY and EXG were actually so much better than AGD and AOD. The problem was that investors were so enamored with the Alpine fund's dividend harvest strategy with 100% investment income distributions that they failed to see what the cost had been to the fund's NAVs. This is what I wrote back on January 13, 2011...

The purpose of this comparison is to show investors the misconceptions of equity based high yielding CEFs and how they can lead to arbitrary market price valuations. The perception that dividend harvest funds such as AGD and AOD have "good" distributions because their dividends are tax-qualified as opposed to "bad" dividends from option-income funds which are mostly return of capital (ROC) is pure nonsense. One has to look at the bigger picture of what the real cost for these distributions has been. Not only have the option-income funds NAVs held up far better than the dividend capture funds since their inceptions, even with their high ROC; one could argue that return of capital is more tax-advantageous than tax-qualified dividends. ROC is tax-free in the period received though an investor would need to lower their cost basis in the fund by the ROC amount. Still, ROC is essentially tax-deferred until the investor sells the fund.

Do you think investors learned anything from when I wrote my article? Let's revisit the total return NAV performances from where I left off on December 31, 2010, up to the current July 16, 2012. But first let me show you how the valuations of the 4 funds have changed since the end of 2010 to see if investors have re-evaluated their perceptions and perhaps corrected their mispricings. I have also included the fund's current market price yields and NAV yields in the table below, which I want to expand upon at the end of the article.

So from December 31, 2010, AGD's premium market price valuation over its NAV actually rose from 1.4% to a current 11.9% while AOD's essentially held steady. In other words, investors believe that AGD's market price is now worth about 11.9% more than the sum of its actual holdings as represented by the NAV. And over the same period of time, EXG's and ETY's discounts have actually doubled from around -7% to over -15% meaning investors place even less value on the fund's market prices now than at the end of 2010 when they were already trading at low valuations.

So you would think AGD and AOD's NAVs must have recovered since December 31, 2010, to deserve an increase in valuation while EXG's and ETY's NAVs must have been performing horribly. Well, let's take a look and see if the markets got this right. Here is the total return NAV performance of all 4 funds from December 31, 2010, through July 16, 2012.

Once again, ETY's and EXG's total return NAV performances are significantly outperforming and are actually positive from December 31, 2010 (shown in green) whereas AGD's and AOD's have fallen even further behind (shown in red). Now on a market price basis, ETY's and EXG's market price have also performed better than AGD's and AOD's since December 31, 2010, so I suppose there is some sanity left but frankly, they should be outperforming by a lot more considering their NAV outperformance.

In fact, ETY's and EXG's NAVs have been far outperforming most international ETFs such as the iShares MSCI EAFE index (NYSEARCA:EFA), one of the most popular and heavily traded ETFs. EFA, which is a benchmark international index trading about 20 million shares per day, represents the 22 international developed country markets and since December 31, 2010 is down -10.3% including dividends. Compare that with ETY's and EXG's positive total return NAV performance over the same period and you wonder why investors keep hammering on EXG's and ETY's market prices down to -15% discounts, which are among the widest of all CEFs.

Now, AGD, AOD, ETY and EXG are all global funds, which means they include U.S. stocks and certainly the U.S. markets have performed better than overseas markets. What's interesting is that EXG has the least U.S. stock exposure of the four at 45% while ETY has the highest at 78% and AGD and AOD both have about 50% as of their latest fund reports. The other interesting statistic is that EXG went public closest to when the financial crisis began later in 2007 so it was the fund at the most disadvantage. AGD went public the earliest on July 26, 2006 (1st table above) and thus had the highest advantage and still, the total return NAV performances between EXG and AGD aren't even close.

So how does this happen? How do investors err so badly in their valuations of these funds? One reason is because investors believe that funds that maintain their exorbitant yields must be doing something right and fund's that have cut their distributions must be doing something wrong. The other reason is that funds with high Return of Capital in their distributions are perceived to be just giving back your investment whereas funds with 100% investment income and positive Undistributed Net Investment Income (UNII) are generating more income than they distribute and thus must be growing their NAVs. This could NOT be further from the truth, particularly in the case of these funds.

If investors would only look at the total return NAV performances, they would realize which funds are in essence, returning their capital. Alpine eventually did cut AGD's and AOD's distributions a whopping 45% and 55% respectively back in June of 2010 and will have to make a large cut again in my opinion, particularly if the international markets remain under pressure. The reason is AGD's and AOD's NAV yields have risen to over 14% because of their NAV erosion (shown in red in 2nd table above), which puts them in the danger zone of needing another distribution cut. Alpine's insistence on maintaining an overtly large yield at the expense of the fund's NAVs will just continue to result in inferior total return NAV performance in my opinion. This story, though not as onerous, is not unlike what recently appeared in the online version of the Wall Street Journal on the Cornerstone funds, another family of Closed-End funds that have ridiculously high yields and valuations without the NAV performance to back it up.

Eaton Vance, on the other hand, has been very proactive in rebalancing its distributions with its income and yet investors have punished their option-income CEFs with the widest discounts of all equity-based CEFs. Eaton Vance, frankly, has been acting in the best interest of investors all along and if investors took a minute to look at their fund's total return NAV performances, they would realize it.

As a result, ETY's and EXG's NAV yields are a much more reasonable 9.5% and 9.9% respectively (as shown in green in 2nd table above), which is not that much different from their inception yields (shown in 1st table). This gives EXG and ETY much more of a cushion to pay their distributions while maintaining their NAV whereas AGD and AOD will struggle to cover their 14% NAV yields while continuing to see NAV erosion, particularly in a continued down global market. Let's not mince words, AGD and AOD have the largest absolute NAV and market price losses from inception of all the equity CEFs I follow and yet they still find investors who believe they can finally turn it around. You just wonder who in their right mind would buy a fund like AGD at a premium? That's like paying 12% over what something is worth just for the right to lose money based on AGD's historical performance.

Does that mean that AGD and AOD will cut their distributions again before EXG and ETY? Maybe...maybe not. But it doesn't matter because what's important is the total return comparisons. The bottom line has been much better total return NAV performances for the Eaton Vance CEFs over all market environments and eventually that will be reflected in the fund's market prices as well. At the end of the day, would you rather own the fund with the best total return performance or the fund with the highest yield?

Because of their -15% discounts, an added bonus to EXG's and ETY's current market price is that investors can pick up a significant windfall yield of 11.8% and 11.1% respectively over their NAV yields. Now if international markets go straight up from here, then AGD and AOD's NAVs should outperform EXG's and ETY's since EXG and ETY are more defensive with an option-income strategy. Still, EXG and ETY have a relatively low 48% option coverage on their global stock portfolios so they will still have strong NAV and market price upside in any global stock market recovery. Investors may be anticipating such a rally and are bidding up the most aggressive global funds once again, but they got it wrong back on January 13, 2011, when I wrote my first article and I even said that I doubted that AGD and AOD were going to turn it around even as investors bid the funds back up.

Finally, if you go to cefconnect.com and go to the Fund Sorter tab, you will find all sorts of overpriced as well as underpriced funds, and you can even see where these four funds rank in terms of Discounts and Premiums among the 600+ total stock and bond CEFs available to investors. For full disclosure, I don't even own ETY or EXG because I believe there are even better global funds to own, but the fact that funds like Alpine's AGD and AOD can so bamboozle investors into thinking that their funds are doing much better than their yields indicate is both a travesty and a disservice to investors in Closed-End funds.

In my experience, valuations will eventually reflect the fund's total return performances and when that happens, funds from fund families like Eaton Vance will see a rise in valuations and funds from fund families like Alpine will see their valuations plummet.

Note: Alpine announced on June 20, 2012, that it would continue the same monthly distributions on AOD and AGD for the next 3-months through September. AGD and AOD go ex-dividend next on July 20, 2012.

Disclosure: I have no positions in any stocks mentioned, but may initiate a short position in AGD over the next 72 hours.