Some people gear their portfolios toward growth in anticipation of drawing their future income from gains. Others invest specifically for income with the plan that their investments will supply their income (through interest or dividends) without drawing out any principal. Perhaps you like a mixture of both strategies.
From my experience investing in closed-end funds (since 2008), I found that a portfolio of CEFs can actually keep pace with a growth portfolio, but with the added benefit of regular and substantial distributions. In this, my first, article on Seeking Alpha, I'd like to share what I've learned about rebalancing a portfolio of closed-end funds.
After I discovered CEFs, I originally allotted about half of my "play money" portfolio (i.e. outside of our core portfolio) to growth stocks and stock funds, and half to income-generating closed-end funds. My plan was to "feed" the income portion with the gains from the growth portion to grow it while keeping the two segments in balance. But the mixture of CEFs I held stayed in step with the growth stocks, and I never had to redistribute between these two "buckets".
Because of this, and because I grew to love dividends, I gradually shifted to a CEF-focused portfolio, and hold a few stock ETFs for added diversity. My goal is to build up an investment portfolio that will provide a monthly income in retirement without ever having to touch the principal. A well-diversified basket of closed-end funds is a great way to accomplish that.
Bear in mind, this is considered a fairly aggressive approach to income investing. Your Emergency Savings must stay out of it. The newbie should dip in slowly and patiently, while learning how to navigate the pros and cons of closed-end funds. In my opinion as a non-professional investor, it is well worth it.
Over the course of two or three years, I settled into a portfolio consisting of 19 CEFs, 3 BDCs, 2 REITs, a handful of bull-market trades through ETFs, and cash. This portfolio covers a broad enough range of assets and sectors that I don't worry about my plans going south, and it gives me the opportunity to take advantage of the market moves within the sectors to improve my portfolio and the income it generates.
REBALANCING: A BEAUTIFUL THING
When holding a variety of closed-end funds, some funds are going to go up while others go down. On the surface, it would seem like rebalancing would just keep your portfolio flat. But it actually makes it more efficient.
For one thing, when you take gains from the fund that has gone up, you're selling high (although only a portion of your stake in it), and when you put that money into a fund that's goes down, you're buying low. This is one of the great tenets of successful investing: buy low, sell high.
Second, as some asset classes move up, even soar, you know that eventually they will fall. Knowing that this is inevitable, you want to take some gains while they're there. As Grandpa used to say, "Make hay while the sun shines." By the same token, as other asset classes fall, you know that eventually they will rise again. Knowing that this is inevitable, you want to pick up some shares while they're "on sale". This is just good economics.
But most investors already understand all this. It's when you actually crunch the numbers that you discover the beauty of rebalancing: your CEF portfolio becomes a well-oiled machine that pumps out better and better dividends, even if you don't invest another penny into it.
Here's how it works: Let's say, for the sake of simplicity, you have an equity fund X and a diversified bond fund Y, which you were able to buy at the same price of $10/share and they happened to both pay a dividend of $0.05/share. You bought 1000 shares of each, costing you $10,000 per fund.
Your monthly dividends come to $100 (total of 2000 shares at $0.05/share). (Of course, these figures aren't so nicely aligned in real life, and I've left out transaction fees, but this makes it easier to see the concept.)
After a time, you notice that Fund X has increased by 10% and Fund Y has gone down by 10%.
You decide that this would be a good time to rebalance, so you sell the gain from Fund X for $11/share, decreasing your shares by 90 and netting you $990 (90 shares x $11). Then you take that $990 windfall and purchase more shares of Fund Y at $9/share, increasing your shares by 110 ($990 / $9 per share).
You now have a total of 20 more shares than you did when you started and just got a raise!
Perhaps a dollar-a-month (or a 1%) raise doesn't sound like much, but when you have a portfolio of, say, 20 funds, then it's likely that at some point 3 or 4 of those funds will be well above their targets, and 3 or 4 will have fallen below their targets. Rebalancing these could easily bring in $5/month more in income in this scenario. And that's just with funds paying only 6%. With closed-end funds (as well as REITs, BDCs, etc.), you can easily get 8-9% yield today. Rebalancing would increase your income even more.
Here's a recent real-life example of the beauty of rebalancing, using just one of my REIT holdings, Government Properties Income Trust (NYSE:GOV): With 163 shares of GOV sitting within a comfortable range of my target of $3,000 for quite some time, the market price gradually fell to about 20% below my target allocation earlier this year. Using the money from the gains off another asset, I purchased another $600 worth of shares in February, bringing the total back up to $3000. My total shares stood at 207. The fund rallied quickly, and soon its market value was 25% larger than its target allocation. I sold $750 on the rally bringing it back down to its $3000 position size.
So, it started at $3000, then dropped so I put in more to bring it back up to $3000, then rallied so I sold the gains to bring it back down to $3000. What good did that do?
Before rebalancing, I had 163 shares. Now, I have 165 shares for the same position size.
My quarterly distribution at .43/share was $70.09. Now it is $70.95. This seems rather small, but my position size is rather small, too, and when you add up these incremental increases over time, your dividends are gradually growing, even without putting new money in!
Another way to rebalance is to have all your dividends (or even new money) invested into the fund that is the furthest below its target. While I also do this with my own portfolio, this is the predominant method I use in rebalancing my parents' CEF portfolio, where each of their positions is given an equal weight. The CEF that is at the bottom of the list for market value gets the dividends of the whole portfolio until it stands at its target weighting again. This is very easy to set up and monitor. Having had this portfolio for 8 years, it is now earning 16% in distributions off their original investment, even while making periodic withdrawals in the past 4 ½ years equal to nearly half of their original invested capital.
There's an additional benefit of some asset classes moving up while others dip: These cycles provide opportune times to move shares to earn better yields. For instance, as fund A increases in market value, its yield falls because, even though the dividend per share remains the same, the dividend is worth a smaller percentage of your position size. As Fund B falls in market value, its yield rises because the dividend is worth a growing percentage of your position size. It is also likely that, because of the nature of closed-end funds, Fund B is trading at a wider discount as it falls. Discounts on solid CEFs are your best friends!
While the yield on your investment remains the same for each of these funds, the yield on their value changes. So, to take some gains off the top of the larger position with a decreasing market yield and putting that money into the smaller position with a widened discount and increasing market yield is putting those market fluctuations to good use.
Here's a real-life example: When I bought Tekla Healthcare Investors (NYSE:HQH), it was yielding 8.76% at .42/share every quarter. The fund soared over the next couple of years until my position size was much too large, and that dividend that had grown to .59/share was still worth only 8.4% of my position size. A very good yield, mind you, but I was looking for something better. I took the gains off the top of HQH (only earning 8.4% by now) and invested that money into the Columbia Seligman Premium Technology Growth Fund (NYSE:STK) that was yielding 12% at that time.
Here's how that played out (pay special attention to the highlighted columns - this is the important part):
Bottom line: Selling those 75 shares of one fund meant a quarterly decrease in income of $44.25, but redeploying that money into another fund created a quarterly increase of $62.90.
Even with an increasing quarterly dividend generated by HQH, rebalancing at such an opportune time increased my dividends by 18.65/quarter by moving it to STK when it pulled back. I also caught STK at a double-digit discount, furthering the effectiveness of the move.
It has proven true for me that rebalancing my portfolio periodically has increased its income output by 11%-21% per year over the past 4 years (when I finally settled on a portfolio and strategy with which I was happy). This rebalancing includes: collecting all the dividends and investing them in the fund or funds that were below target to bring them in line; and taking gains off of positions that become too large (especially if its market yield dropped too much as a result or its price was at a premium) and moving the money into better-yielding funds selling at a discount. I will continue to monitor the output of my income portfolio in the years ahead to ensure that this strategy will handily beat inflation, even if I were no longer to reinvest the dividends.
One other thing I did not touch on is rebalancing a position size when replacing one fund for a better one in the same asset class. While the rebalancing itself in this instance is basically a no-brainer (just sell the old one, then purchase the new fund at the correct position size), the strategy of "trading up" should always be considered. I find Seeking Alpha to be one great way to keep tabs on the funds I own, as well as others on my watch list.
Like many other CEF investors here on Seeking Alpha, I lament the fact that there is a dearth of financial advisories that focus on closed-end funds. Consequently, we have come to rely on each other and the information shared here on this site. Thank you so much, fellow Alpha Seekers!
DISCLAIMER: I am not a professional financial advisor. This article is not meant to be a recommendation for strategy or an endorsement of any particular fund, but rather, a way to share my particular experience. Please do your own due diligence when investing.
Disclosure: I am/we are long GOV, HQH, AND STK.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.