At a whopping 65% premium over NAV, (NYSE:PGP) is not compensating holders for a number of significant risks that can lead to a substantial loss in principal. Investors who purchased PGP at over 100% premium to NAV were battered as they saw the premium compress. Since inception NAV has deteriorate drastically. Additionally, given the current premium, for every $1 dollar you own, any return of capital results in receipt of only .61 cents! This is flat out a horrible investment that should be avoided at all costs.
Why No CEF Should Trade at a Premium
Having worked in the hedge fund industry for many years I believe I have a fairly decent understanding of how institutional investors such as pension funds, fund of funds, endowments and ultra high net worth individuals and family offices approach investing. Regardless of the strategy, these investors embark on an in depth due diligence process with each potential manager than not only evaluates their investment strategy, process and philosophy but also all facets of their operations, from compliance to risk management.
I cannot imagine at any point during this process a potential manger saying to a potential investor, "by the way our portfolio is currently valued at $1 billion but when you invest your $50 million, we want you to pay a premium of 50%. The fund manager would be laughed out of the meeting with a terse "don't let the door hit you in the bum on the way out."
It does not matter how well the strategy has performed, who the manager is, how much monthly cash the strategy is throwing off, no investor would consider paying any sort of premium for a nano second. So why do retail investors in CEFs pay a premium?
The answer is they don't know or they care, but they should know and they should care. Paying a premium for a CEF is making a bet that has no investment rationale. The risk of large capital loss based upon a feature of a CEF that has no rationally explainable basis is not prudent.
There are some who will argue that a CEF can construct a portfolio more efficiently than a retail investor and that a CEF can obtain leverage at much better rates than a retail investor and this is all true. However these efficiencies should be passed along to an investor like they are in a hedge fund. When a CEF trades at a premium these efficiencies disappear.
What's worse is that most CEFs are long only beta strategies that are unlikely to beat their indexes. That alone is a valid argument against paying any significant fees to the manager. This coupled with a premium is virtually insuring you will do worse than the index being tracked.
What is PGP's Investment Strategy?
There is no magic sauce here and no free lunch. PGP is essentially a levered derivative overlay strategy that uses bond collateral instead of cash collateral to theoretically beat its benchmark. An overlay strategy is simply a synthetic replication of an asset class. In PGP the asset classic being synthetically replicated is the S&P 500 index through the use of S&P 500 futures. As a result, exposure obtained by PGP is greater than the actual amount of funds under management due to the leverage obtained via the futures it owns. The fund then writes call options against its S&P 500 exposure attempting to generate gains through the collection of option premiums. Those familiar will know this as a buy-write strategy which is a fairly conservative strategy that limits gains in up-markets and provides some downside protection in down markets.
The second part of the strategy involves what constitutes substantially all of the funds assets which are invested in a debt portfolio of bank loans, corporate and government bonds and other fixed income assets. This portfolio is used to back the derivative strategy.
What's Wrong With PGP?
There have been some good excellent research pieces here on Seeking Alpha discussing PGP in terms of its problems. None of them however have touched on what I think is the absolute worst characteristic of owning PGP. Return of capital at a discount. Given the massive premium in PGP, any time the fund returns capital you are generating an instant loss. You've paid 165% for assets and you are getting some capital back at 100%. OUCH!
Let's consider a fund that holds only cash, with a net asset value of $100 per share. If the fund distributes $10 to shareholders, this is comprised entirely of return of capital because the fund didn't earn any income or book capital gains. The fund's NAV decreases by the amount of the distribution to $90. At the end of the day, shareholders still wind up with $100 ($90 in NAV and $10 in cash from the distribution). The decision to reinvest these distributions and the price at which they are reinvested change this calculation.
Consider now the same CEF with a NAV of $100 per share, trading at a 20% discount (the share price is $80). The fund distributes $10 per share (still return of capital), and the investor has decided to reinvest all distributions back into the fund. Shareholders make out quite well in this case. Assuming investors are reinvesting distributions at the fund's share price, for each $1.00 an investor reinvests, they would then own $1.25 in assets. Alternatively, reinvesting the distribution would be horrifically detrimental if the fund traded at a 65% premium (with a share price of $165). In this scenario, reinvesting $1.00 would correspond to owning just $0.61 in assets. Ouch!
Owning PGP at any significant premium is like playing musical chairs. The music is nice and will continue for some time but eventually the music will stop and somebody will be left without a chair. I have absolutely no doubt that at some point in the future PGP will trade with no premium. Investors can guess and try to play for the distribution yield but while the music is playing the risks are huge.
There are other CEFs that mimic PGP's bond/option overlay strategy that trade at a discount. I will explore these in my next article.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.