I've been reviewing some of my old articles from early 2011 to see how I've done on some of the equity based high yielding Closed-End funds (CEFs) I have written about and also to update and reiterate some of the positions I have taken. The biggest macro call I made in early 2011 when I started writing articles on Seeking Alpha was for investors to overweight the option-income CEFs in anticipation of a volatile but overall flat market environment and that turned out to be the right call. This year I've taken a more aggressive stand and have been recommending the leveraged CEFs for a more bull market environment.
One article I wrote in February of 2011 was titled "Follow the NAV" and in essence, advised investors that if they wanted to know where a fund's market price was headed, all they had to do was follow the Net Asset Value (NAV) of the fund. You can read the article here and I'd like to go over it one more time since I believe it bears repeating, particularly as many investors continue to disregard the NAVs of funds.
Why The NAV Matters: Reason #1 - Discounts and Premiums
The most obvious reason why investors should pay attention to the NAV of a fund is because buying funds at discounts means you can pick up assets below par value whereas buying funds at premiums means you are paying more than what the fund is worth. This is a bit overly simplistic and is, in fact, the least important reason of why the NAV matters. I mean, it's nice to be able to pick up funds at $0.85 to $0.90 on the dollar, but unless you can unlock the value via a liquidation, you won't realize that windfall gain. Nonetheless, liquidations do happen with CEFs as do other corporate events such as maturities and mergers. All of these would be based on the NAV of the fund, NOT the market price. The only event that I'm aware of that takes into account the market price for a CEF is for re-investment or offerings when the market price is below the NAV price.
To give you an example of how unaware most investors are of the relationship between a CEF's market price and its NAV, several years ago there was a family of CEF funds from a firm called IQ Investment Advisors which had 3 equity CEFs with 5-year maturities. One of those funds was the S&P 500 Covered-Call fund (NYSE:BEP) which rose to a 30% or so premium pricing over its NAV less than a year before its maturity. You would be amazed how few investors even knew this fund had a maturity date and that the market price would eventually compress down to reflect the NAV less than a year later. It was the easiest money making short I had ever seen and yet it was completely overlooked by investors because they didn't follow the NAV or perform other due diligence before investing. The rest of the IQ Investment Advisor funds, the Dow Premium & Dividend Income fund (DPD), the Dow Premium Enhanced fund (DPO) and the NASDAQ Premium Income and Growth fund (NASDAQ:QQQX) were later acquired by Nuveen.
The bottom line is that you really only own a fund's NAV if something goes wrong unless you can sell the fund to an unwitting buyer at a premium. For many CEF investors who don't follow NAVs, this can be forgiving if the fund trades at only a slight -5% discount to 5% premium, since as far as I'm concerned, this is essentially trading at par value. It's only when funds start trading at -10% to -15% discounts or 10% to 15% or more premiums, that the valuation comparisons can start to become more meaningful. But again, this only gives you a cursory evaluation of which CEFs may be undervalued or overvalued. To really start to analyze a CEF's true worth, you need to look at its total return NAV performance.
Why The NAV Matters: Reason #2 - Total Return NAV Performance
Though most investors only follow the market price of a CEF, I pay very little attention to it. The market price only becomes important when there are dislocations resulting in wider discounts or premiums of funds due to price spikes. This is when investors have their best opportunities to add or reduce positions in CEFs and as experienced investors know, this can happen often with CEFs! However, on a longer term basis, what investors should be paying more attention to is the Total Return NAV Performance. This requires a lot more work, but in the long run, it is a lot more profitable and will help investors avoid CEF pitfalls.
Total Return NAV performance includes the NAV plus all distributions over time. This is the best valuation metric to compare against other CEFs and benchmark indices and it can be a real eye opener. The reason is that when investors look at the NAV of a fund, they don't see all of the distributions that have been paid. It's only when you start to add back the distributions that the picture becomes much clearer and you can see which funds are actually doing much better, or much worse, than they appear.
For example, if you graph one of my favorite equity CEFs, the Eaton Vance Tax-Managed Buy/Write Opportunities fund (NYSE:ETV) since its inception in June of 2005 against its benchmark, the S&P 500 as represented by the SPDR S&P 500 ETF (NYSEARCA:SPY), it may look like ETV and its NAV...XETVX (typically you put X's around the fund's ticker symbol to get the NAV) have not performed well comparatively. See below.
But what if I told you that if you add back all of ETV's quarterly distributions to its NAV, the fund has actually outperformed the S&P 500? Here is ETV's NAV quarterly total return performance since inception through August 2, 2012 vs. the S&P 500 with all distributions added back, including all dividends for SPY. Green represents up quarters and red represents down quarters.
So not only has ETV's NAV outperformed the S&P 500 since its inception, 38.5% vs. 29.2%, the fund's NAV holds up much better during difficult market periods such as during the financial crisis from late 2007 to early 2009 (see red down market period in table above).
The point I'm trying to make is that once you dig a little deeper and figure out a fund's total return NAV performance, then you can determine how a fund is truly performing against its peers and against its benchmarks. This will then allow you to make informed decisions about which funds may be undervalued (ETV is at a -11.4% discount for example) and which funds may be overvalued.
One of the biggest problems that investors run into when they evaluate CEFs is that they chase funds with too high a distribution compared to their NAV. Funds that continue to offer overly large distributions may on the surface, seem attractive at say, 12% to 15% market yields, but there is usually a cost for that high of a yield and it shows up in a deteriorating NAV. By tracking the total return NAV performance, this will uncover which funds are really just eroding their NAVs and are in essence, yield traps. This leads me into the next reason why the NAV matters - NAV yields.
Why The NAV Matters: Reason #3 - Watch Your NAV Yields
Next to total return NAV performance, the most important reason why the NAV matters has to do with a fund's distribution yield. Most investors are only concerned with the yield on market price when they look at a fund, however, it's the NAV yield of a fund that will tell you much more about the health and well-being of the fund. Not only will the NAV yield tell you which funds may be overpaying their distribution and may be due for a distribution cut but also which funds may be in position to raise their distribution.
I have determined that when an NAV yield of a fund reaches 12% or more, the fund is in danger of a distribution cut. This doesn't mean that a fund will definitely cut and in fact, some fund families are loathe to make distribution cuts even though they should. This works against the interest of investors since the end result is faster NAV erosion if the fund cannot reasonably support its high distributions. Several fund families, including Alpine and Allianz/PIMCO fall into this category and it should not be surprising that many of these funds have subpar total return NAV performances. I follow virtually all of the equity CEFs available to investors and it is frankly incredible how investors get sucked into the highest yielding funds at a premium valuation without realizing that these funds have some of the worst total return NAV performances in their class.
The following table lists the highest yielding equity CEFs sorted by their NAV yields with NAV yields over 12% shown in red. Also included in the table are year-to-date NAV and market price performances as well as market price yields and premium/discount levels. All information is as of July 31, 2012.
The worst offenders of funds with NAV yields in the red zone are the Alpine dividend harvest funds (NYSE:AOD) and (NYSE:AGD) and the Allianz/PIMCO International & Premium Strategy fund (NYSE:NAI). All three of these funds have total return NAV performances at the bottom of their class and yet their fund sponsors continue to overpay their distributions. What's ridiculous is that two of these three funds trade at premium prices which just proves how many investors are just chasing yield and have no idea of how far these fund's NAVs have dropped from inception.
At the top of the list is the Allianz/PIMCO Global StocksPlus & Income fund (NYSE:PGP) with a whopping 18.5% NAV yield, but PGP is a unique fund that uses options and futures and can have periods of extreme up and down NAV performance. PGP has had a very good year so far at the NAV level, up 20% on a total return basis YTD, but the fund is also very volatile and if you back up a year, PGP's NAV total return performance is actually down through the end of July, 2012.
But even PGP will have problems with its uber high NAV yield despite its popularity and reputation as a fund that can do no wrong. PGP's NAV deterioration from $23.83 at inception to a current $11.78 is masking a total return NAV performance that is not as golden as some might think. Compared to ETV's total return NAV performance above, PGP has lagged behind. This is shown in the following table which compares the quarterly total return NAV performances of the two funds since their inceptions beginning at the end of the 2nd quarter 2005. Since both funds use S&P 500 derivatives (options and futures) to help derive their income, this table is particularly relevant.
Now PGP has been no slouch performer but a big reason for ETV's outperformance is that it has done a much better job at managing its NAV yield by cutting its distribution twice since inception resulting in a very manageable 9.3% current NAV yield. Though distribution cuts may seem like a negative, investors need to realize that NAV sustainability is much more important to the long term success of a fund than a high NAV yield. PGP, on the other hand, has never cut its distribution and as a result, has seen its NAV deteriorate much quicker. As a result, PGP's NAV yield has ballooned to 18.5%, twice as high as ETV's at 9.3%.
If investors had been tracking these two funds' NAV yields and total return NAV performances, they would realize which fund has performed better at the NAV level and is in a much better position to maintain both its NAV and distribution going forward. Unfortunately, most investors don't consider a fund's NAV and rely more on the positive reputation of PIMCO or the negative reputation of Eaton Vance to make their decisions. This is very shortsighted and has resulted in ETV trading at an -11.4% discount whereas PGP trades at an incredible 83% premium, the highest of all CEFs.
Why The NAV Matters: Reason #4 - Windfall Yields
However, this discount/premium difference actually results in another reason why the NAV matters and that has to do with the windfall market yield an investor can receive by buying a fund at a discount. Because ETV trades at an -11.4% discount, investors can pick up a windfall market yield of 10.5% over its 9.3% NAV yield. On the other hand, new investors in PGP are only receiving a 10.2% market yield while actually giving up an 18.5% NAV yield the fund has to support. In other words, new investors in PGP actually receive a lower market yield than new investors in ETV!
It can be almost comical how investors value CEFs and its all because they don't follow a fund's NAV and rely more on a fund's reputation or exorbitant market yield. Now PGP is more of a bull market fund and ETV is more of a defensive fund and certainly that will have a bearing on NAV sustainability going forward. But if history is any guide, I will place my bets on funds that have reasonable NAV yields and superior NAV total return performances over all market environments than funds which are not doing investors any favors by maintaining overly large distributions that a fund can't possibly maintain.
I have been following equity based high yielding CEFs since 2006 and my performance over the S&P 500 since that time has been substantial; i.e over 100%. In the short run, CEFs can do some crazy things as investor emotions and market sentiment can result in extreme market price swings. However, at the end of the day, it's the fund's NAV that really only matters and I would advise investors to keep a closer watch on a fund's NAV than its market price for the reasons cited above.
Disclosure: I am long ETV.
Additional disclosure: Short NAI