About four months ago on June 7th, I wrote an article called "The High Cost of High Distributions" in which I showed how ultra high yielding equity based closed-end funds (CEFs) which had overly high net asset value (NAV) yields of 12% or higher were, in fact, yield traps for investors and the end result was far inferior NAV and market price performances. Not only that, I predicted many of the funds would be forced to cut distributions, and in fact, the featured CEF in the article, the Allianz International and Premium Strategy fund (NAI), went on to cut its distribution a very large 31% a few months later and dropped from a 12.1% premium market price at the time to a current -6.1% discount today. You can read that article here.
I wanted to revisit this issue because, quite frankly, there continue to be funds that just defy logic and can somehow trade at lofty premium market prices over their NAVs even though they should all be trading at wide discounts if there was any sanity in the CEF world. It is frankly, a travesty that these funds can trade at such absurd valuations when it is so plainly obvious what a disastrous investment these funds have been historically.
The three funds I want to focus on are the Alpine Global Dynamic Dividend Fund (AGD), the Cornerstone Strategic Value Fund (CLM) and the Cornerstone Total Return Fund (CRF). I want to first show you the NAV yields of these funds as well as the premium market prices investors are willing to pay, and then realize that by paying a premium market price, an investor is not even getting the ultra high NAV yield the fund has to try and support. For example, Cornerstone readily admits that the 21% NAV yields that their funds are set to pay out each year is "not a function of, nor is it related to, the investment return on a fund's portfolio" and yet investors seem willing to pay up to a 25% premium just to get that discounted 18% yield.
Does anybody really believe a fund can offer a 21% yield year-in and year-out without decimating its net worth? Why not pick a 25% NAV yield, or a 30% NAV yield or even a 40% NAV yield? Would investors pay an even higher premium if Cornerstone offered these yields or would they finally figure out this is nothing but a gimmick? It's mind-boggling to think that anyone would fall for this and then to think that someone would actually pay up to a 25% premium for a discounted 18% yield and you realize the insanity of this. What's even more amazing is that investors did pay even higher premiums of up to 60% just a couple years ago for the "right" to own these funds. Even today, all three of these funds reflect some of the highest premium valuations of all equity CEFs available to investors. Here are the current statistics for these funds as of October 17th, 2012.
I've identified NAV yields of 12% or more as funds in the danger zone of needing to cut their distributions or else risk seeing continued NAV deterioration, so you can see that these funds are way off the charts, particularly CRF and CLM at 22%+ NAV yields. Whereas every other fund sponsor I follow places a precedence on maintaining and growing their fund's NAVs even if it means cutting distributions, these funds are essentially amortizing their NAVs in the name of ultra high distributions and yields.
And how has this strategy played out? Here is a 5-year total return market price performance of all three funds compared to the S&P 500, as represented by the SPDR S&P 500 Trust (SPY), the most popular and most heavily traded ETF. Remember, total return means all of those ultra high distributions over this time period are reinvested to show exactly what an investor would have earned over 5 years. Five years also equates to roughly the high of the market back in October 2007 and as you can see, the S&P 500 is roughly flat over that time period but with dividends, SPY is actually up about 5.3%. On the other hand, these three funds have all lost about -50% of their value.
This is about as extreme of an example of why ultra high NAV yields do nothing but destroy NAV total return performance and ultimately, total return market price performance. What's incredible is that investors seem willing to pay a premium market price for funds that clearly are doing nothing but eroding their NAVs to pay for distributions they cannot support. But then there are always investors willing to jump on board these ultra high yielding funds thinking that maybe this time might be different. Unfortunately, this is not going to be the case.
The problem with these funds is that they really offer no enhanced income strategy that will allow them to both cover their distributions and sustain their NAVs over time. And if their NAVs continue to erode, then they have less net worth to work with which makes it that much harder to maintain their current distributions. It's a vicious downward cycle these funds find themselves in and it just amazes me that investors fall for it.
Now these aren't the only funds with high NAV yields that trade at lofty premiums. The PIMCO Global StocksPlus & Income fund (PGP) is another fund which has a very high 16.5% NAV yield and trades at a 46.6% premium (also down from an 80% premium only a couple months ago). But unlike the Alpine and Cornerstone funds, PGP can at least offer exceptional NAV upside when its income strategy is optimized. Year-to-date, PGP's NAV is up a whopping 39.5% because it leverages S&P 500 mini futures from its leveraged fixed-income portfolio and thus can perform like a long option on the S&P 500. However, the same NAV upside potential cannot be said for the Alpine or Cornerstone funds.
The Dividend Harvest Conundrum
AGD is what is known as a "dividend harvest" fund, which means the fund uses paired stocks to overweight one yield oriented stock right before it goes ex-dividend and then rotates assets over to the other stock position before it goes ex-dividend. In this manner, AGD is able to "harvest" multiple dividend periods each year rather than the normal four that a single stock would offer. This may be great for generating lots of investment income and plenty of Undistributed Net Investment Income (UNII), but in the long run, it's an NAV destroyer.
The reason is because a position would have to first appreciate enough to make up the ex-dividend amount before you could rotate assets just to sustain the fund's NAV. If you have the luxury of time, this may not be a problem, but if you rotate assets that have not made up the dividend amount, then you are losing NAV in place of the high distribution. This is a bit oversimplified but that is the gist of the dividend harvest strategy conundrum. AGD also uses a minimum amount of leverage but not nearly enough to sustain such a high NAV yield. I should also note that AGD's sister fund, the Alpine Total Dynamic Dividend fund (AOD), also falls into this category with an even higher 13.7% NAV yield, but at least AOD trades at a discount of -6.4%, however slight that is.
Just What Are The Cornerstone Funds?
The Cornerstone funds are probably the most difficult funds to find historic and current information on since unlike most fund families that provide fact sheets and Annual and Semi-Annual Reports on their company website, Cornerstone doesn't have a company website as far as I can tell. In fact, go to cefconnect.com and click on Fund Sponsor Website for CLM or CRF and the link directs you right back to CEFconnect.com.
So it's not entirely clear what the Cornerstone income strategy is to pay for those 21% NAV yields. It doesn't appear that leverage or derivatives are being used according to the latest SEC filings showing both funds' portfolio holdings as of June 30th, 2012. One investment class that both funds seem to utilize are other high yielding CEFs. CLM includes about 47% of its portfolio invested in other stock and bond CEFs while CRF includes about 20%.
Now investing in other CEFs may be a smart strategy since CEFs can offer high yields and appreciation potential like a stock, but setting a 21% NAV yield distribution each year may be a bit optimistic. Then consider that the funds have to absorb the management fees for the CEFs they own not to mention their own management fees and I don't see how the fund can possibly expect to cover a 21% NAV yield year in and year out. Obviously, neither does Cornerstone. Wouldn't it be a lot smarter for an investor just to buy those same CEFs, many of which are at discounts, and just pay yourself 18% each year, since that is what the current market price yield is on CLM and CRF? You may still see your account erode over time just like these funds' NAVs, but at least you wouldn't be depending on other yield obsessed investors to keep supporting the funds at premiums.
A number of recent articles from Barron's and the Wall Street Journal have helped knock down the absurd premiums these funds (including PGP) reflected not that long ago, but if history is any guide, investors have short memories and the allure of ultra high yields may be too much for investors to walk away from. In fact, year-to-date, here are the total return market price performances of CLM, CRF and AGD... all of which are currently outperforming the S&P 500 as of October 17th, 2012.