Yield, Value, Safety: Available With Closed-End Funds?

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Includes: JFR, MIE, PHYS, PPR, PTY, RQI
by: John D. Thomason

Summary

This article presents a brief review of the history and basics of closed-end funds, and identifies several useful web sites to aid in evaluating them.

The main points to consider when considering investment in a closed-end fund are presented.

The author's actual results to-date from five closed-end funds are then presented, some of which have been held over ten years, to illustrate how these funds may perform over time.

Introduction

Closed-end funds [CEFs] have been in existence for more than 100 years, according to CEFA, the Closed-End Fund Association. The modern version of investment companies stems from the Investment Company Act of 1940 (1940 Act), which defines responsibilities and limitations of all investment companies, including CEFs, and provides for their regulation by the SEC. A key feature of most investment companies is that their investors escape double taxation of gains, dividends, and interest, as long as the firm qualifies as a Regulated Investment Company (RIC) by meeting certain requirements defined in the 1940 Act. A key RIC requirement is that at least 90% of profits must be passed through to the individual shareholders. Closed-end funds are but one type of investment company, and are very similar to open end funds, commonly known as mutual funds, with some key differences. Most CEFs are also RICs, and their holders benefit from the pass-through feature.

Basics

The CEFA web site at cefa.com provides an outstanding presentation of CEF basics, under the “LEARN” selection on the home page. Some highlights, which point out some key differences from open end investment companies (mutual funds) follows.

A CEF has a fixed number of shares, and is established as a tradeable security via an Initial Public Offering (IPO), like any stock. All subsequent buys and sells are between investors, and do not involve the fund company. This illustrates one advantage of a CEF over a mutual fund, in that during a time of market stress, the fund manager will not be required to sacrifice quality holdings to raise funds to meet redemptions.

CEFs trade just like stocks, so purchasers can use limit orders and other devices not available for acquiring regular mutual funds. While a CEF will roughly track the value of the holdings, the price is also affected by supply and demand, and frequently, CEF shares will trade at a discount to the underlying value of the fund holdings. This is a rare phenomenon in the markets, where you can buy an asset for less than the market value. Of course, it can work the other way, whereby a CEF can trade at a premium to the value of its holdings, but more CEFs trade at a discount than at a premium.

CEFs offer all the benefits of mutual funds, such as transparency, diversification (within the boundaries of the funds’ strategy and focus), professional management, convenience, liquidity, and so on.

Advantages over regular mutual funds are that the management expense ratio, publicly available, is the only fee. There are no initial “load” charges, or 12b-1 fees. While a brokerage commission is required to buy or sell, in these days of rock-bottom commissions, that is not the hindrance it once was.

Because they don’t have to deal with redemptions, most CEFs utilize leverage to improve returns. The high distributions of many CEFs are only possible through leverage. Of course, this increases risk and volatility, and it must be noted that payouts from CEFs, or yield, can vary substantially over time. Payouts WILL BE reduced if the fund runs into trouble. On the other hand, it is pretty unlikely that a CEF will go completely under. My case studies of five CEFs I have owned at the end of this article, some for over 10 years, will illustrate these points clearly.

For further explanation of these topics and much more, visit the CEFA web site previously recommended. Also, another industry-sponsored web site, cefconnect.com, also has some informative explanations of these topics, under the “Education Center” selection on the home page.

Evaluating CEFs

There are over 600 active CEFs available today. Bond funds dominate, accounting for around two-thirds of the capital at work, according to CEFA. Other types are equity funds, both diversified and industry-specific sector funds, global and international funds, country-specific funds, funds concentrating on preferreds or convertibles, MLPs, REITs, or commodities, and other variations. Both of the afore-mentioned web sites have extensive evaluation tools available. The best brokerage web site for CEFs I have found is Charles Schwab, followed by Fidelity. With Schwab, you enter the CEF symbol, and the site will recognize the entry as a CEF, and will present a wealth of information, including a report, the CEF Report Card. Morningstar ratings for the CEF are provided, along with the current and historical discount or premium. The CEFA and Cefconnect web sites also provide a lot of data, including a chart comparison of the share price vs the value of holdings (NAV) over time. When evaluating a CEF, the key elements are as follows:

Discount/Premium

Is the fund trading at a discount or a premium to NAV? Not only just now, but over the years. One of the key attractive features of CEFs is that they can often be bought at a discount. While discounts vary, 5% to 10% is not uncommon. Even if so, don’t expect a quick profit. Funds trading at a discount usually have done so for years. On the other hand, if the discount has widened recently from the historical norms, now may be an opportunity for a great entry point. Two of the funds presented in my case study below were available at extreme discounts in December 2016, when I bought, and both have rebounded since entry, validating that the extreme discount was temporary. As for funds trading at a premium, the performance has likely been outstanding, but frankly, I’m just not interested if there is no discount, at least 3% to 5%. If the discount has widened recently, and it is because of the asset class that the fund is focused on is out of favor, not a huge performance issue unique to the fund, I am even more enticed.

Fund Expenses

What is the expense ratio? This is usually presented as two figures, gross and net, by the evaluation tools referenced. Frankly, particularly if leverage is employed, this figure will be higher than most mutual funds, and certainly more than index funds or ETFs. For comparison purposes, I would consider a given CEF under consideration against other CEFs, not against mutual funds or ETFs, before rating the fund as to the expense ratio. Although I am willing to accept that CEFs have higher expense ratios than other types of funds, I certainly don’t want it to be any higher than necessary. A net expense ratio more than 2% seems high to me. If funds under consideration seem to be about equal in other respects, the one with a lower expense ratio will be more enticing.

Distribution / Yield

What is the current distribution / yield. Let’s face it, a primary attraction CEFs have is availability of high yields. How high? If not at least 6%, I can’t see taking on the extra risk of a leveraged CEF. Yields in the 8% to 10% range are not uncommon, and are not necessarily indicative of too high of a risk to be considered. The distribution history should also be reviewed. If the fund has been around long enough to have experienced the 2008 crisis, take a long look at the distribution before, during, and after 2008, to see what happened. Another test is to determine the yield considering income only from holdings vs income actually being paid out. The CEFA web site detail shows the 12 month yield for income only vs the actual distribution. This can be a real eye opener, as you will see how much leverage and possibly return of capital (see next paragraph) is contributing to the payout you are receiving.

If the fund has a set payout, i.e. a managed distribution policy, a portion of distributions may be provided by a return of capital. The 1099-DIV received at year-end will show this. Obviously, if very much of the distribution is funded by a return of capital, a distribution cut is likely if performance does not improve.

I would not consider a CEF with an actual yield under 6%, and I would avoid funds with an artificially high yield from a managed distribution policy. As for the distribution history, if the payout was reduced during 2008-2009, but has recovered to a reasonable yield today, I would not be too concerned, considering what took place.

Investment Approach

What is the fund’s investment approach? This has two facets; what does the fund invest in, and to what extent is leverage employed? In addition to the CEFA and Cefconnect websites, I find the quantum web site I primarily use for preferreds research to be useful. The web site is quantumonline.com. A free registration is required. Upon entering the symbol, a summarized profile is presented, and a link to the fund’s web site is provided.

The Schwab detail indicates the top 10 holdings of a fund, the percent of the total portfolio invested in the top 10, and the total number of holdings. The main take-away here is to get a sense of how closely the fund is following the strategy expounded in the prospectus, and the degree of concentration in holdings. While I hesitate to lay out any hard rules here, you expect the holdings to reflect the types of investments the fund states they will invest in, and you might be leery if the fund's resources are too concentrated into too few names.

The majority of CEFs employ leverage. If you are leery of funds utilizing leverage, you probably should pass on CEFs. The Cefconnect web site provides some detail on leverage as of the end of the most recent year. The CEFA web site takes a bit more work, but you can get this information under the main heading “Fund Selector”, by selecting "Leveraged Funds”, then narrow down the 400+ choices by Fund Advisor, such as Cohen & Steers, then by symbol for the fund you are investigating. The percent of leveraged assets indicates roughly the extent to which leverage is employed. A leverage percentage in the 25% to 30% range is typical, and is certainly acceptable. Above 30% is not necessarily a disqualifier, but indicates there may be more risk and volatility with the fund.

Taxes – PFIC Issue

As for taxes, dividends from CEFs are reported on a 1099-DIV received from your brokerage, and are reported the same as dividends on stocks. Unlike stocks, CEFs will also frequently distribute capital gains to shareholders annually, usually late in the year, and these will also be reported on the 1099-DIV, and will be reported on Schedule D or directly on the 1040 if Schedule D is not required. As for sales of CEFs, these will be treated by your brokerage the same as any stock sale, and a 1099B will be provided, necessitating filing a Form 8949 and Schedule D.

Rarely, an investor may acquire shares of a CEF which is considered a Passive Foreign Investment Company (PFIC). The most common example of which I am aware is the Sprott Physical Gold Trust (NYSEARCA:PHYS), a Canadian CEF which seems to be the most effective way to invest in gold bullion without actually owning physical gold. If you are an American investing in PHYS, you should acquaint yourself with the requirement to file IRS Form 8621 with your tax return for the year you first become a holder of PHYS. This will allow you to treat your PHYS holding as a Qualified Electing Fund (QEF) and allow you to be taxed on gains when you sell at capital gains rates (usually only 15%) instead of collectibles rates (28%). See the funds’ web site for details on this recommendation.

This illustrates that before buying into any CEF, or any investment for that matter, it is a good idea to take a look at the fund’s web site to see if there are any tax reporting requirements beyond what you are expecting. If so, hopefully the web site will address this topic thoroughly, like sprott.com does.

Seeking Alpha CEF Coverage

In addition to the resources mentioned earlier, Seeking Alpha can be a useful resource as well when evaluating CEFs. There are several authors on Seeking Alpha who write about CEFs regularly. Of course, the best way to find out if there is anything available on a particular CEF is to enter the symbol in the search box. But to just survey recent articles on CEFs, select the main heading ETFs and Funds, then the sub-heading Closed End Funds. A long list will be presented. As you proceed through the list, you will see that some authors have multiple articles out on CEFs. You can then list articles by author if a particular author has produced some articles of interest, to see what else he/she may have written about. If you are not familiar with CEFs, I suggest going over the CEF basics at the CEFA and Cefconnect web sites before diving into specific articles.

Five CEF Case Studies

From the foregoing, it should be obvious that CEFs involve some risk, to go along with their high yields. For illustration, I am going to present my investing results for five CEFs I currently own, some for over 10 years. While I don’t plan to sell anytime soon, I will show what my results would be if I sold as of the end of day price on 7/25/2017. Of course, if I sold, my price could be any price at which the CEF traded on that date, not necessarily the end of day price. The results are presented in a table in the next section.

The five CEFs are:

  • Nuveen Floating Rate Income Fund (JFR)
  • Voya Prime Rate Trust (PPR)
  • PIMCO Corporate and Income Opportunity Fund (PTY)
  • Cohen & Steers Quality Income Realty Fund (RQI)
  • Cohen & Steers MLP Income and Energy Opportunity Fund (MIE)

Note that I am not necessarily recommending these funds. I picked these from among the 25 or so CEFs that I own as being good subjects to review. I have some that have done better, and some that have done worse. Pay particular attention to the distribution range for the two that I have owned for over 10 years, to see what happened during the financial crisis of 2008-2009.

As implied in the distribution range over the holding period, the two CEFs purchased in 2006 were hammered by the financial crisis. JFR’s monthly payout dropped from 9 cents to as low as only 4 cents per share, and even today has only recovered to 6.75 cents. The initial distribution of 9 cents per month was the high water mark for the distribution, and is unlikely to be regained in any time frame that matters to me personally. Similarly, PPR’s monthly payout dropped to as low as 2 cents per share from the initial 5 cents, and has recovered even less, percentage-wise, than JFR, to only 2.5 cents. The three CEFs purchased long after the crisis have fared well so far, with distributions unchanged. If a new crisis of a similar magnitude comes along, chances are these payouts will be cut. Still, when you consider what happened, the fact that JFR and PPR continued to pay out SOMETHING all along, and are still paying out today, shows the survivability of CEFs.

Summary – Final Thoughts

I believe that CEFs have a place in an income portfolio. A CEF with a high yield obtained with leverage is definitely higher on the risk spectrum than a solid blue chip yielding 2% or less, but based on my experience, involves less risk than a high-yielding BDC, Mortgage REIT, or MLP, because of what I view as a higher likelihood of surviving a market / economic crash. Still, the percent allocated to CEFs should be capped, say somewhere between 10% and 20% of a portfolio. Further, a basket of CEFs should be defined to provide diversification between asset classes or sectors, and this needs to be coordinated with your over-all investment allocation. For example, if you are over-weight energy stocks, investing in energy CEFs is going to make you even more over-invested in energy.

As for the expense of investing in CEFs caused by the fact that a brokerage commission is involved for each acquisition, I will introduce you to a new type of brokerage I have been using for over a year now, Motif. The web site is motifinvesting.com. The essence is you can create a “motif” of your own construct, which can be a basket of up to 30 stocks or ETFs, with each stock weighted by a percentage that you specify. Of course, the total percentages in your “motif” must add to 100%. Then, you can invest funds into the stocks specified by your “motif” (minimum amount $250), and the funds will be used to buy the specified securities in your “motif” in the proportions specified. Only one $9.99 commission is charged for the entire purchase. I have established a couple of “motifs” of CEFs, and have been quite impressed with the capabilities of this brokerage. It certainly solves the problem of excessive brokerage commissions being required to acquire a basket of CEFs, especially when you prefer to acquire positions incrementally, as I do, and not have your entire position in a holding dictated by where the markets stood on one given day.

In my case, 30 CEFs would be excessive, and I can’t see any reason to weight them other than equally, so my “motifs” are 10 CEFs each, weighted equally.

In conclusion, I must include my usual admonition that I am not certified or accredited in any way as an investment advisor. I am an individual investor, semi-retired, and seeking income from my investments. My objective is to continue to progress in my overall knowledge of investing, and share my investing results and lessons learned with my fellow investors.

Disclosure: I am/we are long PHYS, JFR, PPR, PTY, RQI, MIE.

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.

Additional disclosure: In addition to being an investor and occasional SA author, I am employed by a national firm as a Tax Practitioner, and I have attained Enrolled Agent status with the IRS, which is recognition given to candidates who have passed three Special Enrollment Exams and have maintained continuing tax education requirements.