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I have been investing in closed-end funds (CEFs) since about 2005. Over the past seven years I have learned a lot from them - both positive and negative. But I think the overriding lesson is this: CEFs have a place in the Protected Principal Retirement portfolio.

In this article we will look at what a closed-end fund is, how it trades, how we should evaluate them, and finally which ones are most appropriate for us mid-rangers.

What Is A Closed-End Fund?

A closed-end fund is a publicly traded company that initially raises capital by selling a fixed amount of shares via an IPO. This differs from a mutual fund (an open-end fund) which can issue new shares at will.

The typical closed-end fund consists of a number of stocks that are actively managed (for a fee) by an investment advisor. CEFs typically focus on specific industries or market sectors such as bonds, preferred stocks, utilities, MLPs, REITs, foreign countries or regions, among others.

The value of a closed-end fund fluctuates according to market supply and demand and based upon the value of the securities it holds. Therefore, the price per share is determined by the market and can be substantially different than the net asset value (the market value of all fund securities minus liabilities divided by the number of outstanding shares) of its stock portfolio. At any given time, the market price of a closed-end fund can be greater (a premium) than, or less than (a discount) its net asset value. I have recently read where approximately 27 percent of all closed-end funds are presently trading at a discount.

In addition, many CEFs use leverage as a means to enhance yield. Feelings are mixed about leverage, and I personally am not put off by it (since it can enhance the funds returns, particularly in a bull market) so long as the percentage is low.

Two SA authors that have written many substantive articles on CEFs are Douglas Albo and Tim Plaehn. In addition, there are two excellent websites that provide information on CEFs: the Closed End Fund Association (cefa.com) and CEF Connect (cefconnect.com). CEF Connect also has a very good screening tool.

Premiums, Discounts And Dividends

Who among us does not enjoy buying things on sale? CEFs can (and do) trade at discounts or premiums to their net asset values. If a closed-end fund trades at a price of $10 and its net asset value is $11 the discount would be a little over nine percent. So buying at a discount affords us the opportunity to buy shares for less than their actual value (like buying a quart of milk that sells for $1.10 for $1.00). I personally believe that risk goes up in tandem with increasing discount, so we need to do research to determine why a given closed-end fund is selling at a discount.

CEFs can also trade at a premium to their net asset value (we don't like this and we don't buy them at premiums unless there is a very good reason).

There are a number of factors that affect discounts and premiums including: relative fund performance and yield, illiquid holdings, liquidity pressures, a "name" manager or management team, or unrealized appreciation.

CEFs pay dividends in two ways: income dividends and capital gains distributions, and are generally comprised of one or more of: dividend income, interest income, capital gains (short and long-term) and return of capital. These can be paid on a monthly, quarterly, semi-annual or annual basis. Income from CEFs is generally taxable (except from municipal bond funds), and capital gains may be paid at the end of the year.

Like common stocks, dividends can fluctuate with earnings, and be increased or decreased accordingly. There are CEFs that pay managed distributions - these provide a more stable, predictable rate of cash flow for the investor.

Before proceeding with evaluative selection criteria I wish to touch on Return Of Capital [ROC]. Many investors cringe when they see that all, or a portion of their dividend is categorized as "return of capital". While I shy away from CEFs where a large percentage of the dividend is return of capital, a small portion just doesn't trouble me as much - just my opinion. Delving into the topic we find that return of capital can be either constructive or destructive. One way to tell if [ROC] is constructive is to compare the fund's net asset value prior to and after the distribution period. If the net asset value is equal to, or greater than it was prior to the distribution, then the [ROC] is deemed to be constructive.

Evaluative Criteria

If I am considering investing in an asset class that lends itself to wider diversification (foreign stocks, mREITs, and the like), I generally look to CEFs. I prefer them to mutual funds since they offer higher yields and I can usually buy them at a discount.

I adhere to the following criteria when I evaluate a closed-end fund:

  • I do not buy IPO's - ever! CEFs generally decline by eight to 12 percent in the first 100 days of trading. The issuer generally has to support the price for about a 45 day period subsequent to the IPO. Once their buying support is ended the price generally drops substantially. Best time to buy a closed-end fund IPO is about three to six months after trading begins.
  • Look for low expense ratios - as close to one percent as possible.
  • One of the writers on SA (forgot who) claims that when the fund yield exceeds 12 percent of the net asset value a dividend cut might be on the way. This certainly seems to be the case more often than not.
  • Look at the dividend yield against the net asset value, not just the stock price.
  • In 2005, Forbes published an article on CEFs that included two criteria that also seem to have substantial validity. It suggested that when you purchase a stock closed-end fund, the discount should be at least ten times the fund expense ratio. So if the fund you are looking at has an expense ratio of 1.5 percent, the discount should be at least 15 percent. Forbes also claimed that when buying a bond closed-end fund the discount should be at least twelve times the expense ratio. For municipal funds the discount should be 16 times the fees.
  • Finally a good principal for buying and selling CEFs is to buy when the discount is at least ten percent and then sell when it reaches a premium of 10 percent.

I'm certain there are many others; however, these are a good starting point.

The Protected Principal Retirement Portfolio And CEFs

I have mentioned a few CEFs in the prior article on REITs, so I will not go back over them here. Aside from those discussed in the article on REITs, the Protected Principal Retirement portfolio presently contains three CEFs: Alpine Total Dynamic Dividend Fund AOD (let's hear the boos), Gamco Global Gold & Natural Resources Fund GGN and ING Global Equity Dividend & Premium Income Fund IGD. CEFs that are being considered include: Calamos Global Dynamic Income Fund CHW, Cohen & Steers Global Income Builder Fund INB, Cohen & Steers Infrastructure Fund UTF and Gabelli Global Multi-Media Fund GGT.

The table below presents pertinent data on each.

SymbolD/P*YieldDiv Freq.LeverageFeesPerfor. YTD
AODD 8.0%15.2%Monthly6%1.35%+8.2%
GGNP 2.2%12.2%Monthly9%1.36%+4.8%
IGDD 5.6%12.4%Monthly0%1.24%+12.1%
CHWD 9.4%8.9%Monthly27%1.93%+19.9%
INBD 3.8%10.2%Quarterly21%2.01%+24.1%
UTFD 8.1%8.0%Quarterly32%2.19%+18.8%
GGTD 7.9%11.1%Quarterly20%2.61%+22.9%

* Discount or Premium

All data is taken from information provided by CEF Connect as of the close on 8/7/12.

From the table one can see that with the exception of GGN, each of the CEFs have performed relatively well year to date. Those that are a part of the Protected Principal Retirement portfolio are characterized by higher yield, low leverage, low fees, and pay monthly dividends. Let's take a more detailed look at each:

AOD - Alpine's Total Dynamic Dividend Fund is roundly despised by most everyone. In July 2010 the unsustainable dividend was reduced from $.12 to $.055 per month. The yield to net asset value is 13.97 percent. At present, 40 percent of the dividend is classified as return of capital. So, aside from a healthy yield (that could be further reduced) what's to like about AOD? I purchased it for its exposure to several foreign markets that I believe have favorable prospects - Sweden, Brazil, Switzerland, Norway, Australia and Singapore. I would be lying if I said I have been pleased with its performance; however, I will continue to exhibit patience for a few more months.

GGN - Gamco (formerly Gabelli) Global Gold Natural Resources & Income Fund has been my vehicle of preference for the past two years for its exposure to gold, silver and other natural resources. I am not a gold bug, nor do I have enough funds to diversify by buying the metals or the mining stocks. I also like their exposure to energy stocks. They also use an options strategy to elevate dividends. The yield to net asset value is 12.44 percent. GGN is close to its 52 week lows at the present time and I am looking to add to the portfolio's position.

IGD - ING Global Equity Dividend And Premium Opportunities Fund invests in a global portfolio and uses an options strategy to enhance yield. I added IGD to the portfolio in June of this year and have been satisfied with its performance (particularly the increase in net asset value). Although the distributions contain a healthy percentage of return of capital, in recent months this has been constructive. The yield to net asset value is 11.70 percent. The fund's holdings are heavily weighed to U.S. stocks (71%).

CHW - Calamos Global Dynamic Income Fund seeks total return through investments in convertibles, common and preferred stocks, and debt securities. I have had this one on my watch list for a few months and am close to initiating a position in the Protected Principal Retirement portfolio. The monthly dividend was raised in January of this year, and virtually all of it is from income. The current yield to net asset value is 8.04 percent. Ninety eight percent of CHW's investments are global.

INB - Cohen & Steers Global Income Builder Fund is also a total return fund. The sectors owned include: REITs, utilities and MLPs, and they also use an options strategy. The yield to net asset value is 9.86 percent. I believe that this fund is quite unique among CEFs due to its sector diversification, and I look to add it to the portfolio on any decent drop in share price. Their holdings presently consist of 51 percent U.S. stocks with the balance allocated among some of the stronger European countries and Asia.

UTF - Cohen & Steers Infrastructure Fund at one time was almost exclusively focused on utilities; however, it is now more widely diversified among global infrastructure companies. The objective of the fund is a high level of total return. The present yield to net asset value is 7.41 percent. Their portfolio consists of 60 percent U.S. stocks and is globally diversified among electric and gas utilities, cell towers, toll roads, airports and energy MLPs. About 12.5 percent of their holding are in France and Italy - a little scary.

GGT - Gabelli Global Multi-Media Fund focuses on intellectual property rights and is classified as a growth and income fund. The yield to net asset value is 10.20 percent. The relatively high fee is well offset by the fund's record of appreciation year to date. Seventy-six percent of its holdings are in U.S. stocks.

Other CEFs Of Interest

In my research I sought out CEFs that had the longest strings of up years. These are the ones I came up with:

  • FDI - Fort Dearborn Income Fund has increased its market price every year since 2000. Currently has a 4.1 percent yield.
  • ICB - MS Income Securities has increased its market price every year since 2003 and currently has a 4.2 percent yield.
  • VBF - Invesco BK Bond Fund has increased its market price every year since 2000. Yield is 4.4 percent.
  • FMY - First Trust Mortgage Income Fund has increased price every year since its inception in 2006. Fund yields 9.6 percent but presently is selling at a premium of 13.6 percent.
  • MIN - MFS Intermediate Income Fund has increased its market price each year since 2000, yields 8.1 percent and sells at a premium to net asset value of 4.6 percent.

I have tried to touch on a few of the approximately 660 +/- CEFs traded on U.S. stock markets. The Protected Principal Retirement portfolio does not have a specific allocation percentage to CEFs, as they are used within several categories (REITs, foreign stocks, currency and commodities) to achieve our desired yield level. Those CEFs mentioned in this article presently provide and average yield to our portfolio of approximately 13 percent.

Next up - Business Development Companies.

Source: Protected Principal Retirement Strategy: Retiring Without A Million-Dollar Nest Egg - Part VII

Additional disclosure: Once again, I am not a registered investment advisor and am not making specific purchase recommendations. Rather, I am presenting a strategy for consideration by those at, or nearing retirement age. I am also long GGN and IGD, both of which are valid symbols.