CEFs: Income Strategies for All Market Seasons

by: Douglas Albo

The accompanying table of equity based Closed End Funds (CEFs) is intended to compare the Net Asset Value (NAV) and yields of these funds since inception so that the reader can determine which funds have best preserved their NAV while maintaining a balanced income and distribution policy. These 46 funds represent the majority of high yielding equity based CEFs available to investors and collectively represent about $29 billion in assets. What’s interesting about these funds is that all of them became public during the 2004 to 2008 time frame and all at $20 per share. Because of these similarities, this makes for a very revealing side by side comparison.

I have further divided these high yielding equity based CEFs on their income strategies and will discuss below how each strategy earns its income and in what market environment they work best in.

I should first start with a couple notes. First, this analysis only looks at the NAVs of these funds and not their open market prices or whether they trade at discounts or premiums. I’m a firm believer that if you follow a fund's NAV, you will follow where the market price ultimately goes. Too many investors either disregard or don’t know about a fund’s NAV and only consider the market price and yield of a fund. Investors should realize that a fund’s dividend is derived from the NAV and is dependent on the sustainability of the NAV. I would urge investors to pay closer attention to a CEF’s NAV because this will reveal to you the health of the fund and whether it may be due for a dividend cut or even a dividend raise.

Second, high yielding equity based CEFs means that the fund has a current NAV yield of at least 6% and that at least two-thirds of the fund’s portfolio is invested in domestic or global stocks. I do not follow or invest in pure fixed-income CEFs due to their heavy use of leverage and unverifiable valuations for less liquid securities. Since most of the equity based CEFs listed here are invested predominantly in well-known large capitalization stocks either domestic or global, accurate portfolio valuations and liquidity are not a concern.

And third, the three income strategies discussed below are general in nature. Some of these funds may use a combination of strategies and of course, each fund has a unique portfolio of stocks and/or other securities that will contribute to the fund’s overall performance. My intention is to give investors some insight as to how these strategies work and which market environments may optimize each strategy.

The Option-Income Strategy

The first income strategy that high yielding equity based CEFs use is the option-income strategy. Option-income CEFs generate income by selling covered-call individual stock options or index options against a portfolio of domestic or global stocks. Most of the option income portfolios include only large capitalization stocks with little if any fixed-income securities. Leverage is usually not needed for this strategy as the premium earned by selling options against the fund’s portfolio usually represents 40% to 100% of the notional value. Option-income CEFs excel in up and down markets in which no clear trend is established but will lag in NAV performance during strong market or low volatility periods. This is not to say that option-income CEFs won’t appreciate in a strong market environment, they just won’t outperform. However, option-income fund NAVs will hold up much better than any of the other strategies in a difficult market environment and will even outperform the broader market during these periods. It should be noted though that option income funds are not immune from NAV erosion in an extended bear market environment and dividend cuts can and have occurred.

The Leveraged Strategy

The second income strategy that high yielding equity based CEFs use is the leverage strategy. Funds that utilize this strategy generally leverage up a portfolio of high dividend paying stocks so that the leveraged positions just increase the income of the fund. Many of these funds also include up to one-third of their portfolios in fixed income investments such as preferred or corporate bond securities to offer diversification and reduce leverage risk. As you might expect, these funds do best in strong equity market environments as well as when interest rates are going down. NAVs can solidly outperform the broader market during these periods and dividend raises are not uncommon. On the other hand, leverage can work against these funds during falling markets or in a rapidly rising interest rate environment. In such conditions, leveraged funds will see their NAV’s contract faster than the broader market and the fund manager may be forced to either reduce the leveraged percentage and/or cut dividends if the NAV gets too depressed. Though riskier than the option-income funds, the leveraged funds offer more potential for capital appreciation along with their dividend yields.

The Dividend Harvest Strategy

Though this is not a widely utilized strategy, there are a few popular CEFs that use a dividend harvest strategy, notably from the Alpine family of funds. The dividend harvest strategy generates additional dividend income periods for the fund by overweighting high dividend yielding stocks ahead of their ex-dividend dates. Once a position has locked in the dividend, then assets can be rotated to another high dividend yielding position ahead of its ex-dividend date, and so on and so forth. In this manner, multiple dividend periods can be harvested and in return, the fund can offer tax-qualified dividends to investors. The dividend harvest CEFs are almost entirely global stock driven and thus, need a strong global equity market environment to excel. Their strategy necessitates a high turnover rate, up to 2,000%, which can lead to frequent realized losses in a difficult market environment since a position would first need to make up the dividend amount just to break even. These funds also tend to overpay their dividends because of their frequent harvesting which may be good for earning high rates of tax-qualified income but can come at a steep price in loss of NAV during difficult market periods. The jury is still out as to how successful this strategy is. The high payouts combined with the market fallout from late 2007 to early 2009 has left these funds with more depressed NAVs than most of the other funds even after the market runup over the past 22 months. Nonetheless, these funds tend to earn the highest valuations in a bull market.

Table notes: 'Current Dividend' is annualized from the latest distribution period and 'Inception Yield' annualizes the first recurring distribution level. 'Inception Price' does not take into account a sales credit which started these fund's NAV's in the low $19 range. Much of this information is available from the Nuveen sponsored website cefconnect.com which is an excellent source of information for investors in Closed-End funds. Also, some of this information may have changed since the end of 2010.

Disclosure: I am long ETV, ETW, EXG, ETY, EVT, DPO, ETJ, EOS.