Equity CEFs: Don't Judge A CEF By Its Yield

by: Douglas Albo


Yield is the most common factor that investors use to buy CEFs. The higher a fund's yield, the more popular the fund and typically the higher the valuation.

Though CEFs generally offer some the highest average yields of any asset class in the financial markets, income investors can easily fall into a yield trap.

And if interest rates eventually rise, investors should be placing even less emphasis on CEF yields and more emphasis on a fund's yield stability and NAV growth.

It's a given in the Closed-End Fund (i.e. CEF) universe. The higher the yield offered to investors, the higher the fund's valuation typically. Equity CEFs that offer around 9% or more yields often trade at premium valuations, while funds that offer 5% or less yields typically trade at wide discounts.

The problem with this strategy is that investors often think that any fund that offers a uber high yield of 9% or more is somehow deserving or is doing something special to justify its high yield. This is hardly ever the case. In fact, the vast majority of funds that offer such a high yield are usually suffering Net Asset Value (i.e. NAV) stagnation at best and significant NAV deterioration at worst with the end result being poor total return performance (i.e. including those high distributions).

The reason is simple. If a fund cannot cover its distribution (and all funds do for periods of time when their income strategy may not be optimized), then destructive Return-of-Capital (or ROC) results. ROC in CEF distributions does not necessarily have to come at the expense of a fund's NAV and can actually be tax advantageous, but if a fund cannot reasonably be expected to cover its distribution then you should expect the NAV to deteriorate, even under favorable market conditions for the fund.

This is because for each pay period that results in a net reduction of the fund's NAV, the end result is that there is that much less capital to generate income to pay the next distribution. It can be an accumulative downward spiral of NAV destruction and yet you would be surprised how many investors fall for these yield traps.

The "Alice In Wonderland" Funds

Perhaps no CEFs exemplify this "Judge me by my yield, not by my NAV performance" more than the Cornerstone family of funds. I call these funds the "Alice In Wonderland" funds in which Alice stands for "Amortizing losses in closed end" funds. In essence, investors are often losing in principal what they are being paid out in distributions, which is analogous to amortizing their capital with what they think is a generous payout. The end result is often a net loss over time for the fund's NAV and worse, a net loss for the investor depending on when they invested.

The three Cornerstone funds - the Total Return fund (NYSEMKT:CRF), $5.76 market price, $4.93 NAV, 16.8% premium; the Strategic Value fund (NYSEMKT:CLM), $6.15 market price, $5.51 NAV, 11.6% premium; and the Progressive Return fund (NYSEMKT:CFP), $4.62 market price, $4.32 NAV, 6.9% premium - "offer" the highest annualized yields of any of the 580 or so Closed-End Funds (bond or equity) available to investors, from 18% up to 20% currently.

And just what do these funds do to justify these incredibly high yields? Nothing special as far as I can tell other than investing in stocks and other CEFs. In fact, Cornerstone is quite upfront when they say...

These distributions are not tied to the Fund's investment income or capital gains and do not represent yield or investment return on the Fund's portfolio. The Distribution Amount from one calendar year to the next will increase or decrease based on the change in each Fund's net asset value. The terms of each distribution policy will be reviewed and approved at least annually by the respective Board and, as always, can be modified at their discretion for the benefit of the Fund and its stockholders.

The last few years, Cornerstone has set the NAV distribution rate at 21% annually, though how they come up with this incredibly generous distribution percentage is unclear. Nonetheless, investors seem quite willing to buy CRF, CLM and CFP at hefty market price premiums of up to 50% or more at times over the last few years (though "only" 7% to 17% premiums currently) for the right to own and receive such a high distribution. What many don't realize is that by paying a market price premium, they are not even receiving the 21% yield the funds are paying out of their NAV.

And what happens when the fund's NAVs erode to a point where new capital is needed? Well, Cornerstone then conducts a Rights offering to existing shareholders to buy additional shares at a discount to the current market price but at a premium to the NAV. Ugh... who falls for this?

Why A CEF Yield Means Nothing Without NAV Growth

The bottom line is that a CEF's yield is irrelevant if the fund can't support it. This is because, like stocks, mutual funds and ETFs, CEF market prices and NAVs are reduced at each distribution when they go ex-dividend. If this didn't occur then yes, yield would play a much larger role in a fund's valuation. But because of the ex-dividend reduction for funds, a CEF's yield should actually be a minor consideration compared to the fund's total return performance, i.e. yield plus appreciation. In other words, whether a CEF's yield is 5% or 15%, it doesn't matter because it's still going to have to make up that distribution at both the market price and NAV level each year before it can add to total return performance.

So if it's really total return performance and not yield that investors should be focused on, which equity based CEFs have seen the best total return performance at the NAV level while offering a reasonable yield along the way? Well, here are the top 35 or so equity based CEFs (out of roughly 100 I follow) sorted by their total return NAV performance since 2012, which is about the time in which the current bull market really started its uninterrupted ramp up. NOTE: Pure REIT or pure MLP equity CEFs are not included.

For comparison, the S&P 500 was up 59.3% without dividends and the SPDR S&P 500 Trust (NYSEARCA:SPY) was up 66.5% with dividends over the same period of time from 12/31/2011 through 8/31/2014. NOTE: All dividends and distributions are added back but not on a re-invested basis.

CEFs have TWO Total Return Performance Figures

Unlike other securities, CEFs give you two prices to track and it's the difference between the two that gives rise to their premium/discount valuations. The NAV of a fund is the true value, i.e. the liquidation value of the fund and is the most comparable to its benchmarks. The market price of a fund is established by investors and is subject to the whims and emotions of the market, often wrong in my analysis.

So even if the best performing equity CEFs shown above may have had difficulty beating the S&P 500 at the NAV level, they still could have easily outperformed at the market price level. This is why you keep track of fund valuations, i.e. the difference between the two prices, since even if a fund's income strategy may not be fully optimized in the current market environment, and most include either defensive option selling, fixed-income securities and/or are globally invested, that doesn't mean the fund's market price can't still outperform its benchmarks. This is shown in the table above in the Total Return Market (Mkt) column next to the Total Return NAV column (shown in green).

You'll notice that I never even mention yield because again, yield is a subset of total return, i.e. yield + net appreciation = total return. Oh sure, it's nice to have a higher yield from a fund but it's insignificant compared to its total return NAV performance or valuation. So when analyzing what funds may be attractive as an investment, I look first at a fund's historic NAV performance and valuation and then at the fund's current portfolio allocation and income strategy. Yield is a tertiary concern though funds that pay monthly vs. quarterly would be an advantage as are funds that are raising their distributions.

Certainly leveraged CEFs (shown in orange above) are generally more bull market oriented and option-income funds (shown in light blue) are generally more defensive but you can't always rely on that either. That's because most CEFs are asset allocated in equities, derivatives (options) and/or fixed income securities so the funds tend to have offsetting securities to reduce volatility as well as generating income. If a fund is sector specific then of course it will be much more dependent on the sector it is invested in, though valuations can still overcome that.

So where are the best equity based CEFs currently based on my analysis? Let's take a look.

The Best Equity CEFs Based On Valuation And Performance

Going back to the CEF listing above, the number one fund on my list is still the Gabelli Healthcare & Wellness Rx fund (NYSE:GRX) - $10.17 market price, $11.49 NAV, -11.5% discount - a fund that I have written about and endorsed numerous times. Since its inception as a spinoff on 6/19/2007, not long before the financial crisis hit later that year, GRX has had a total return of over 100% at the NAV level (see below). Only two other equity CEFs come even close to that, the H&Q Healthcare (NYSE:HQH), $28.31 market price, $29.39 NAV, -3.7% discount and the H&Q Life Sciences fund (NYSE:HQL), $22.48 market price, $23.30 NAV, -3.5% discount, both of which I own but consider to be a lot more risky and volatile.

However, in the minds of most investors, GRX's low market price yield of only 4.7% makes it unattractive, resulting in a wide -11.5% discount. But this is where investors miss out because GRX is much more of a growth fund than an income fund and can be surprisingly defensive during difficult market periods due to its portfolio of healthcare and consumer staple stocks.

In other words, like HQH and HQL above, GRX is much more about capital gain distributions than income generation and Gabelli could spread out the large capital gain distributions GRX has been generating over the past years into a much higher quarterly pay yield for GRX, exactly like what H&Q (Tekla Capital Management) does for HQH and HQL, both around 7.5% NAV yields (8% market yields). So if Gabelli offered say, a 7% or so NAV yield for GRX, which is still conservative compared to its over 11% average annualized NAV return since inception (Source: Semi-Annual Report dated 6/30/14), would GRX trade at a much lower discount or perhaps even a premium market price valuation? Undoubtedly.

Oh wait, it gets better. For the last two years, Gabelli has given existing GRX shareholders Rights offerings to purchase more shares of the fund at significant NAV and market price discounts. Sort of a "thank you" for being a shareholder while adding assets to the fund. This move may dilute the NAV to a degree, but it's still a great deal to existing shareholders and the fund can more than absorb the dilution considering its NAV growth. Contrast that to the Cornerstone funds mentioned above, which have used Rights offerings priced at a significant premium to the NAV to try and prop up the diminishing assets of their funds, and the difference is like night and day.

A Comparison That Speaks Volumes

I'm going to do one more comparison of GRX as an example of a low upfront yielding CEF to another CEF that trades at an even more ridiculous premium due to its high yield and sterling reputation. If you go back to the CEF list above, you'll see that just ahead of GRX in terms of total return NAV performance since 2012 is the PIMCO Global StocksPlus & Income fund (NYSE:PGP), $25.95 market price, $14.54 NAV, a fund that earns the highest market price premium of any CEF at 78.4%. Now PGP is a high risk/high reward fund based on its highly leveraged portfolio of high yield bonds and S&P 500 mini futures and yet it has barely outperformed GRX at the NAV level during one of the great fixed-income and equity bull market periods of all time.

But that's not what I wanted to show you. Let's go back even further and include a down market period to see how these funds have performed historically in all market environments. This is shown in the following cumulative quarterly NAV performance of GRX and PGP since GRX's inception in June of 2007 (PGP's inception was about 2-years earlier in May of 2005). NOTE: Green equals up quarters for the general markets while red equals down quarters.

Is this possible? GRX's total return NAV performance since inception is over 100%, far outperforming PGP's NAV over the same period of time, and yet PGP's market price trades at a 78.4% premium over its NAV compared to GRX's -11.5% discount. That's almost a 90% market price valuation difference for funds that even during a ramp up market since 2012 haven't shown that much NAV performance difference.

How do investors not see this? All the distributions are added back so what difference should an 8.5% current yield vs. a 4.7% current yield make? Certainly, the funds have much different portfolios and income strategies, but should that account for the massive valuation difference? PIMCO may be a great fixed-income manager, but when it comes to equity management, I believe Gabelli is one of the best stock pickers around.

But this is what happens when investors look at yield and reputation first and disregard everything else. Yes, PGP has never changed its $0.1834/share monthly distribution, even during the depth of the financial crisis in 2008-2009, but which of these funds has been raising its distribution over the last couple years and which fund is in a much better position to raise going forward? Well, when you see GRX's NAV yield at an incredibly low 4.2% and PGP's at a red flag 15.1%, it should be pretty clear.

And finally, if this hasn't convinced you how utterly shortsighted most CEF investors are, just take a look at how GRX's NAV has grown since inception from $8 to $11.49 today, while PGP's has gone the other direction from $28.21 to $14.54. Even if high yield bonds and the S&P 500 somehow dramatically outperform healthcare and consumer staple stocks going forward (highly unlikely), this is still lunacy.

But investors may finally be starting to wake up considering GRX's 95.6% market price performance since 2012, far eclipsing any of these other premium priced funds.


Once you look past the smoke and mirror upfront yields that many equity CEFs offer, you begin to see which funds and which fund sponsors truly have the best interest of investors in mind. Ultimately, this will show up in a fund's Net Asset Value performance and in time, it will show up in its market price performance as well. The lesson to be learned is simple... don't judge a CEF by its yield.

Due to the length of this article, I will come back with some more equity CEFs that may not offer the most generous yields, but can still offer investors exceptional total return NAV performance at low valuations.

Disclosure: The author is long GRX, HQH, HQL.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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