Equity CEFs: The Perils Of Being A Defensive Investor

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Includes: ASG, BST, BXMX, ETY, FB, GOOGL, MS, NFJ, NIE, QQQ, QQQX, RMT, RVT, SPY, STK
by: Douglas Albo
Summary

You don't hear of "Growth at a reasonable price" anymore. Probably because it doesn't work like "Growth at any price."

The outperformance by the technology sector is so overwhelming, one wonders how anyone could stay in business by not including a healthy dose of it even in a balanced portfolio.

However, if you look at technology focused CEFs, there definitely has been a chill or two of late.  Are technology CEFs telling us something?

Morgan Stanley, one of the largest holders of CEFs, recently downgraded the technology and small cap sectors.  Could there be a connection?

We've all been waiting for some sort of a rotation that would finally mark a high in the technology sector while starting to see some other sectors finally participate. Theoretically, this would also make for a healthier market as well.

I also have been waiting patiently but so far, there have only been short and sporadic hints of such a rotation. Nothing, and I mean not the threat of government intrusion over advertising on social media nor the taxation of online purchases has been able to even faze the technology sector.

The Invesco NASDAQ-100 QQQ Trust (QQQ), $179.61 market price, hit an all time high on Friday and many other technology focused ETFs are at or close to all time highs as well. No sector has dominated the markets like technology and the fears of another year 2000 (remember Y2K?) bubble have certainly made the rounds though technology stocks have come a long ways since 2000 when earnings were few and far between.

And how are technology focused CEFs faring? By and large, very well too still, but there have also been some scares of recent and the largest holder of CEFs, Morgan Stanley (MS), recently put out a research piece downgrading the technology and small cap sectors:

MSresearch.TechSmallCapDowngrade.pdf

So is this marking a high for the technology sector? I could certainly see why Morgan Stanley might make such a call based on seasonal and valuation red flags, but there has been no sign that technology is in trouble and Morgan Stanley's call has more to do with the business cycle. The big argument in favor of the technology sector continuing to outperform is the assumption that China and tariffs can't really hurt the large cap technology stocks since China doesn't really allow them to have a large presence or do much business in their country to begin with. Google (GOOGL) for example, chooses not to enter the country based on human rights issues. Facebook (FB) is not even allowed in China. So the technology sector remains the only sector you can rely on to bounce back from just about any negative news.

And if you look at the top performing equity CEFs YTD based on total return NAV performance, seven of the top 10 are technology focused when you include all market caps.

In the #1 position, as it has been for the past couple years, is the BlackRock Science & Technology fund (BST), $34.89 market price, $32.04 NAV, 8.9% premium, 5.2% current market yield.

As many of you know, BST was my top aggressive pick for 2017 but it has just continued to outpace every other equity CEF here in 2018 as well, up 18.9% at NAV and a whopping 34.6% at market price just in 2018. BST has been so dominant, even I had to question how much higher it could go and put out a sell in my Marketplace services program on June 1st when the fund hit $34.29.

And as you can see from this YTD chart below, BST got as high as $35 over the next few days after my article before pulling back to the sub $33 level. But that was only temporary and BST has come storming back and even clipped the $35 level again on its ex-dividend date last Friday.

Chart
BST Total Return Price data by YCharts
Chart

BST Total Return Price

data by

YCharts

But BST has been more of an anomaly in the technology sector and if you look at the other technology focused CEFs among the top 10, valuations have definitely come down for most though premium valuations still litter the top funds as you can see in the list above.

In the #2 spot is the Eaton Vance Enhanced Equity Income II fund, (NYSE:EOS), $17.53 market price, $17.31 NAV, 1.3% premium, 6.0% current market yield, a fund that used to trade as high as a 6% premium but has dropped now to only a 1% premium. EOS uses the Russell 1000 Growth index as its benchmark, but make no mistake, EOS is a technology fund.

EOS 1-Year Premium/Discount Chart

In the #3 spot is the Liberty All-Star Growth fund (ASG), $6.77 market price, $6.14 NAV, 10.3% premium, 6.5% current market yield.

ASG 1-Year Premium/Discount Chart

Though ASG also showed some weakness in early June when it got down to almost par valuation, it has since jumped back up to a 10% market price premium and is now the #2 total return market price performer YTD at 26.4%.

The next few funds are more healthcare and general equity focused but getting down to the #7 position is the Royce Micro-Cap Trust (RMT), $10.30 market price, $11.08 NAV, -7.0% discount, 7.0% current market yield. RMT is a medium-sized holding of mine along with the Royce Value Trust (RVT) and though RMT doesn't necessarily fall into the technology sector so much, it is certainly a growth fund that is also assumed to be largely immune from tariffs due to its domestic micro-cap stock focus (up to $1 billion in market cap). RMT has certainly seen its valuation improve though it still has the widest discount of all the top 10 performing funds.

RMT 1-Year Premium/Discount Chart

In the #8 slot is the Nuveen NASDAQ-100 Dynamic Overwrite fund (QQQX), $24.73 market price, $23.97 NAV, 3.2% premium, 6.8% current market yield, a fund I (and a number of other contributors) have been negative on for awhile due to its high premium vs. a low NAV beta compared to its QQQ benchmark.

QQQX's NAV is only up 8.6% when its benchmark, QQQ, is up 15.7% YTD. So why should QQQX trade at a premium? It shouldn't and that's one reason why QQQX's valuation has come tumbling down of late, all the way from an 18% premium to only 3% currently.

QQQX 1-Year Premium/Discount Chart

Now another reason why QQQX has come down sharply is due to a 3.7 million share offering registration with the SEC so it will be interesting to see if QQQX can bounce back from that overhang though no date has been set for the offering. I would be surprised if it did.

In the #9 position in NAV total return performance is the Columbia Seligman Premium Technology fund (STK), $22.00 market price, $21.62 NAV, 1.8% premium, 8.4% current market yield. Historically, STK has been one of the best CEFs to own to cash in on the technology boom but over the last year, STK has been anything but booming at market price, up only 3% YTD and only 9.3% year over year. This is reflected in STK's diminishing premium valuation.

STK 1-Year Premium/Discount Chart

I'm not sure what the reason for STK's underperformance has been but maybe like a fine bottle of wine, the feeling may be to drink it while it hits maturity instead of holding on until it goes bad.

And finally in the #10 position is a recent high flyer, the Allianz Global Equity & Convertible Income fund (NIE), $22.98 market price, $24.28 NAV, -5.4% discount, 6.6% current market yield. NIE wasn't always so focused in technology and it used to be a rather boring fund. I know, because it used to be one of my largest positions though I have largely (and wrongly) moved over to the Allianz Global NFJ Dividend, Interest & Premium fund (NFJ), $12.70 market price.

NIE's valuation has been moving up while NFJ's, a more value oriented and defensive fund, has been moving down. Here is NIE's 1-year premium/discount chart.

NIE 1-Year Premium/Discount Chart

Though on a market price basis compared to NFJ, it hasn't been even close and NIE has run away from NFJ over a 1-year and longer basis.

Chart

NIE Total Return Price

data by

YCharts

That's what you get for trying to be defensive and buy value when you believe a rotation is at hand. Well, I guess if Morgan Stanley can be guilty of it, so can I. But have they been?

Is Morgan Stanley Early Or Just Plain Wrong?

I would urge you to read the research link at the top of this article which downgrades the small cap sector to an equal weight and downgrades the technology sector to an underweight. Because Morgan Stanley has really been right on calling the rise of the utility sector recently and is beginning to look more right on the small cap sector (though I am long RMT and RVT, I am also hedged in inverse small cap ETFs).

And when it comes to CEFs, you had better listen to Morgan Stanley, because they are the 800-lb gorilla when it comes to showing up as a large if not largest holding of many CEFs. I even wrote an article on this back on June 1, 2015 titled, Equity CEFs: Follow The 800-Pound Gorilla.

In that article, I recommended two of Morgan Stanley's favorite equity CEFs, the Eaton Vance Tax-Managed Dividend Equity Income fund (ETY), $12.44 market price, $12.44 NAV, 0% premium, 8.1% current market yield and the Nuveen S&P 500 Buy/Write Income fund (BXMX), $14.21 market price, $14.07 NAV, 1% premium, 6.9% current market yield, in large part because of the influence Morgan Stanley plays in CEFs.

Since that time, both funds have done very well as seen in this approximately 3-year total return comparison with the S&P 500 (SPY), which also includes dividends.

Chart

ETY Total Return Price

data by

YCharts

The bottom line is you should take heed in CEFs when Morgan Stanley speaks, because if they have cut the technology sector to underperform, they could easily cause havoc among technology CEFs if they decide to sell even partial positions. And if you don't believe me, just check out the largest holders of each of the technology funds mentioned above.

Conclusion

There is no question that if a resolution or even a thawing of the tariff dispute between the US and its trading partners, particularly China, comes about (and it may be a series of steps), there are other sectors besides technology that should benefit more, not so much because technology wouldn't benefit but because these other sectors have so much more ground to make up.

Then there's one other factor that is mentioned in Morgan Stanley's report that may be of even more concern than trade tariffs. Trying to get ahead of the curve, or more appropriately, an inverted curve, is what Morgan Stanley is also recommending.

Though there has been a smattering of talk regarding an inverted yield curve between longer term Treasuries, say the 10-year and shorter term maturities, say 2-year Treasuries, other headlines, most notably between tariffs and Trump tweets, seem to still overwhelm everything else.

But don't be surprised when the markets finally react to this inversion since this is generally not good news for the economy. It isn't so much signaling that business conditions will deteriorate but that business conditions will have peaked and when that happens, you're going to want to be in sectors that are more defensive and out of sectors such as technology.

Here is a recap of Morgan Stanley's sector breakdown of what to own and what to lighten up on. We'll just have to wait and see if they are right on this because up until now, it's been a lot more perilous to be a defensive investor.

Disclosure: I am/we are long RMT, RVT, NFJ, NIE, EOS. 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.