Living Dangerously: A Taxonomy Of 'Bad' CEFs

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Includes: EDF, EDI, GUT, MFD, PGP, PHK, RCS
by: ADS Analytics
Summary

Distribution cuts from PIMCO and Allianz brought disappointment to some fund investors this month.

We suggest a framework for thinking about unattractive funds across a number of key metrics.

The usual suspects of EDI, EDF, GUT, PGP, and PHK reoccur in a number of our screens.

Whether April showers will indeed bring flowers to the fund market remains to be seen, but showers there were indeed for some investors this month when a number of high-flying PIMCO and Allianz closed-end funds cut their distributions. These funds were rewarded with double-digit price drops as investors expressed their disappointment with what previously appeared to be high and stable distribution rates.

What followed was a predictable sequence of commentary, with some investors expressing disappointment with the cuts, while others pointed out what seemed just a matter of time to many. Our own blog entry tried to offer a constructive approach to this particular issue, suggesting a set of metrics investors could follow going forward.

In this article, we propose a number of simple screens that investors can use as a way to highlight funds with unattractive characteristics.

A number of funds that re-occur in several charts below are:

  • Local EM Debt funds - Stone Harbor Emerging Markets Total Income Fund (EDI) and Stone Harbor Emerging Markets Income Fund (EDF), particularly for their high premia, lack of distribution coverage, and poor historical returns
  • The very same PIMCO funds that recently cut distributions still appear unattractive: PIMCO Global StocksPLUS & Income Fund (PGP), PIMCO High Income Fund (PHK), PIMCO Strategic Income Fund (RCS)
  • Equity funds Gabelli Utility Trust (GUT), Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund (MFD) having negative net NAV returns, low distribution coverage, high baseline expense for MFD and high premium for GUT

It is often said that investing comes down to finding winners and avoiding losers. Our experience tells us that finding winners is a lot harder than avoiding losers, so it's worth concentrating on the thing one can more easily control.

What we wanted to do in this article is to provide a framework or a common language for investors that they can use in evaluating funds, particularly unappealing funds, as well as to begin a conversation around the characteristics that we, as fund investors, should demand from management teams before entrusting them with our capital.

To this effect, we have come up with a number of scatter charts which combine two different metrics in a single narrative. We admit that basing a narrative around two metrics is quite reductive and often misses out on the bigger picture. However, we take inspiration from equity analysis, which is often done in the form of ratios of two metrics, and if one ratio does not tell us much, a dozen or so often does get quite close to the heart of the matter.

The charts below can make it seem like we are suggesting that there is a sharp dividing line between "good" and "bad" funds or that just because a fund is seen in one of the charts, it is non-investable. Instead, we think the funds exist along a continuum of quality, which is itself a multi-dimensional concept which varies across investors. The taxonomy we lay out below is just the start of the conversation. Let us know your thoughts, if you disagree with any of the criteria and what we have missed.

Risk-To-Distribution Funds

In our experience, we have found that funds which eventually cut distributions often exhibit two characteristics: they show negative net NAV (ex-distribution) returns and lack full distribution coverage. We think the former metric is useful because a fund that overdistributes will be under more pressure to right-size the distribution if it is unable to pay it out of NAV growth.

In the chart below, we show funds that have negative 3Y net NAV growth and distribution coverage <100%.

Source: ADS Analytics, TIINGO

Significant Price-Risk Funds

As we keep seeing again and again, funds trading at a premium which cut their distributions often have steep price drops. The chart below attempts to capture funds which are not covering their distribution and are trading at a premium. These funds are at a higher risk of a severe price drop if and when they do cut.

Source: ADS Analytics, TIINGO

Double-Risk Funds

The name refers to two risks: firstly, funds that have high NAV yields are either investing in particularly weak assets or are overdistributing, and secondly, funds that are trading at a premium are more vulnerable to price drops.

Source: ADS Analytics, TIINGO

Expensive Non-Performer Funds

This chart captures funds which have poor absolute 5Y NAV returns (the figure is not annualized) and are trading at a premium. These funds are likely attracting investors because of optically high distribution rates, which often blinds investors to their poor track record.

Source: ADS Analytics, TIINGO

Expensive Laggard Funds

This type of fund has a high baseline expense while underperforming the sector. The suggestion here is that if the fund is charging a lot for performance, it should be able to deliver this performance in the form of beating the sector average return. These funds do not do that.

Source: ADS Analytics, TIINGO

Tactically-Expensive Vs. Sector

This chart relies on two relative metrics we have developed: discount sector spread percentile (difference between the fund's discount and the sector average expressed as a percentile ranging from 0 to 1) and yield sector spread percentile (difference between the fund's 12-Month yield the sector average expressed as a percentile). Tactically-expensive funds are those which are trading at a tighter discount to the sector and a lower yield to the sector than has been the case historically. It does not mean these funds are bad investments strategically - they are just looking tactically expensive.

Source: ADS Analytics, TIINGO

Conclusion

The old adage has it that investing comes down to picking winners and avoiding losers. However, experience suggests that picking winners is often harder than avoiding losers. To this effect, we come up with a number of screens which attempt to help investors find and avoid funds which have excessive risks or unattractive features. Playing defense may not seem as exciting as racking up the points on offense, but we think it is as essential to long-term investment success.

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.