The Audacity Of CEF Valuations - ETY And AGD Revisited

Includes: AGD, AOD, ETY
by: Douglas Albo

From time to time, I like to point out the extreme valuation differences that equity Closed-End funds (CEFs) can get to based on factors that are often ridiculously short-sighted. On January 13th, 2011, I wrote an article addressing the conundrum that investors often have on high yielding equity based CEFs which offer "good" distributions vs. CEFs which supposedly offer "bad" distributions.

In the article, I compared four funds from two fund families that have different income strategies they use to offer high yield distributions to investors. Two of the funds use a strategy which offers 100% ordinary income distributions and thus were considered "good" distributions, while the other two funds use a strategy that includes high Return of Capital [ROC] percentages in their distributions and thus, were considered "bad" or "destructive" distributions. As it turned out, the fund's that offered "bad" distributions had in fact, far outperformed the funds that offered "good" distributions when you compared Net Asset Value [NAV] total return performance over similar time frames.

I wanted to re-visit two of the funds' short term and longer term performances and re-emphasize to investors that simply looking at the makeup of a fund's distribution as either "good" or "bad" can belie what is really going on with the funds. I will use the Eaton Vance Tax-Managed Diversified Equity Income fund (NYSE:ETY) which has a high ROC component in its distributions as one fund and the Alpine Global Dynamic Dividend fund (NYSE:AGD) which is 100% ordinary dividend income in its distributions as the other.

As I pointed out in the January 13th article, the reason why these funds make good comparisons is that 1) They are both global stock funds with no fixed-income or bond securities, 2) They both came public around the same time in the 2nd half of 2006. 3) They both came public at the same inception price of $20 and the same inception Net Asset Value [NAV] of $19.06 and 4) They both had similar inception yields at around 9.50% and similar current market yields at 12.6% for ETY and 12.2% for AGD. As a result, we should be able to learn a lot about the success or failure of these two funds and their income strategies regardless of the makeup of their distributions. Correct?

Before I go into the performances of these two funds, there are some differences that I should point out. First, ETY, at $1.6 billion in assets, is a lot larger than AGD at $138 million and second, both funds have different global stock portfolios, with ETY more heavily weighted in US stocks at 74% vs AGD at 46%. However, the primary difference between the two funds is their income strategy, and if you are not familiar with how these two strategies work, you can read about them in one of my prior articles.

ETY is an option-income fund,and option-income funds tend to have high Return of Capital (ROC) percentages in their distributions due to their portfolio management. More on that later. AGD is a dividend harvest fund which generates lots of tax-qualified income by "harvesting" multiple dividend periods through active portfolio management. But how have these funds done over time in the area that should really matter to investors, total return?

The following table shows the quarterly total returns of both funds since inception back in 2006. Total distributions for a quarter are simply added back to each fund's Net Asset Value (NYSE:NAV) and a running Total Dividends, Adjusted NAV and Total Return percentage, is shown. Because ETY went public a few months later than AGD, I used ETY's inception date of November 27th, 2006 as the start date. AGD also started with a $19.06 inception NAV on July 24, 2006, but it had grown to $20.89 by November 27th. Note: Green represents positive quarterly periods and red represents negative periods. As you can see, the total return performance is not even close with ETY's NAV, down only -1.7% on a total return basis compared to AGD's at -30.4% over a similar roughly 5-year period. As much negative feedback as I get on the Eaton Vance option-income funds because of their poor market price performances and high ROC percentages, the fact of the matter is their NAV total return performances going back to their inceptions have been excellent. In fact, for most of the Eaton Vance option-income funds, their NAV total return performances not only trounce most other fund families, most even beat the S&P 500. So why is it that the Eaton Vance option-income funds continue to have the widest discounts of all the equity CEF fund families? I can only speculate that because of NAV under-performance for most option-income funds during the ramp-up bull market in 2009 and 2010 which resulted in distribution cuts for many of these funds, that the skepticism continues to this day.

However, virtually all equity CEFs cut their distributions over the past several years, either because of the bear market from late 2007 through early 2009 or due to the ramp-up market recovery from early 2009 to April of this year. AGD, in fact, has cut its distribution twice since 2009 and at a much steeper percentage than ETY; 65% compared to 37%, so I don't understand why investors give AGD the benefit of the doubt and reward it with a current 7.5% premium market price over its NAV, while a fund like ETY, which has far outperformed AGD by any measure, is penalized with a -14.3% market price discount. Does that make sense to you?

Let's look at shorter 1-year NAV performance for both funds in which global markets have had mixed performances. Over the past year going back to October 14th, 2010, ETY's NAV is down a scant -1.6% while AGD's is down -9.9%, again including distributions. How about year-to-date through through October 14th? ETY's NAV is down -5.1% while AGD's NAV is down a whopping -16.1% including distributions. So with those kind of short- and long-term performance statistics, one would think investors would be running for the exits on AGD and instead, bidding up a fund like ETY whose income strategy is actually more advantageous in this volatile up and down market that we've seen for most of 2011. Not really. Here is AGD's 1-year premium/discount chart in which investors seem willing to take another chance on a fund that has had the 2nd worst total return performance of all equity CEFs I follow, 2nd only to its sister fund the Alpine Total Dynamic Dividend fund (NYSE:AOD). And now, here is ETY's 1-year Premium/Discount chart for a global fund that is essentially flat on a similar 1-year total return basis. This is one of the most amazing things about CEFs. That a global stock fund that by virtually any measure has been an abysmal failure can still find investors willing to buy it at a premium when there are other global stock funds that have higher yields and have held NAV value significantly better over the years go begging at -14% discounts. Would someone please explain this to me. Now I don't own ETY because I think Eaton Vance has even better funds to own, but the difference in how these two global funds are looked upon and valued is so mind-bogglingly ridiculous that it defies logic.

The only advantage AGD has, in my opinion, is its monthly pay feature, but that hardly makes up for its other shortcomings, including a signficantly higher expense ratio at 1.56% compared to ETY's 1.07%. I can only guess that investors must believe that a global market recovery is in the works and now is the time that AGD's portfolio and dividend harvest strategy will finally start outperforming. Maybe so, but if history is any guide, it didn't happen when investors bid up AGD to a 50% premium back in the spring of 2010 when its NAV was at around $7.50 instead of its current $5.50, so why should it happen now?

Frankly, I would have to see a market price yield closer to 18% to accept the risk that AGD has shown, and if that's the case, that would put AGD's market price at $4 and a -27% discount to its current $5.49 NAV. Considering that ETY's discount is currently at -14.3% with a higher market yield and significantly better historic performance through up and down markets, I don't think that is inappropriate. So I go back to the distribution make up. Could it be that because AGD's distributions are 100% ordinary income and ETY's are mostly return of capital that investors continue to look more favorably at AGD? Could investors really be so short-sighted? Do investors even realize that ROC can be more tax-advantagous than tax-qualified ordinary income distributions because ROC is considered non-taxable in the period received, though an investor would need to reduce their cost basis by the ROC amount?

In fact, many option-income funds are managed to maximize ROC because of the tax-advantages. How can they do this? By realizing losses in most any market environment, fund managers can often designate much of their fund's distributions as ROC. In a strong up market, funds can realize losses in their options positions, but that can be more than offset by the unrealized appreciation of their stock holdings. Still, distributions can be designated as ROC even while the fund's NAV grows, albeit not as fast as the broader market. In a prolonged weak market, funds can realize losses in their stock positions but that can be partially offset by realized gains in their option positions. Again, distributions can be partially designated as ROC even as the fund's NAV may be holding up better than the broader market.

I know parts of this article may seem confusing to a lot of investors, but let me just conclude by again stressing that investors need to look beyond the simplistic make-up of a fund's distribution to decide whether a fund is a good investment or not. Often, it's the funds that no one wants that offer the best investment opportunities.

Disclosure: I am short AGD.

Disclaimer: I am not a tax expert and each investor should consult with a tax professional before making investment decisions based on the information contained in this article. Additionally, I have no relationship with any of the funds mentioned in this article.