5 Best CEFs To Buy For June 2019 (Income Series)

|
Includes: BME, BTO, CAF, QQQX, RNP
by: Financially Free Investor
Summary

For income investors, closed-end funds (CEFs) are an attractive investment class that covers a variety of asset-classes and premises high distributions and a reasonable total return.

In the CEF world, it is hard to figure out which funds to buy and when to buy. But we will try to separate the wheat from the chaff.

In this monthly series, we highlight five CEFs that have a solid track record, pay high distributions, and are offering "excess" discounts.

We will go over our filtering process to select just five CEFs from around 500 closed-end funds.

For income investors, closed-end funds, or CEFs, are an attractive investment class that offers high income generally in the range of 6-10%, broad diversification in terms of a variety of asset classes, and market matching total returns in the long term if selected carefully.

However, CEFs come with their own set of risks and challenges that the investors should be aware of. We list various risk factors at the end of this article.

For regular stocks, there are several well-known metrics that we could use to figure out if the stock was overvalued or undervalued at a given time, though it is not easy. But it is even harder to figure out which CEF funds to invest in and if they are attractive buys at a given point in time. This is what this series of articles does; to attempt to separate the wheat from the chaff in the CEF world.

Starting February this year, we started a new monthly series, where we highlight five CEFs that are relatively cheap, offer "excess" discounts to their NAVs, pay high distributions, and have a solid track record. We also write a monthly series to identify "5 Safe and Cheap DGI" stocks. You can read our most recent such article here.

We use our multi-step filtering process to select just five CEFs from around 500 available funds. The selected five CEFs this month, as a group, are offering an average distribution rate of 7.22% and offer an average discount of 4.69%. Since this is a monthly series, there may be some selections that could overlap from month to month.

Please note that these are not recommendations to buy, but should be considered as a starting point for further research.

Goals for the Selection Process

Our goals are simple and are aligned with most conservative income investors, including retirees. We want to shortlist five closed-end funds that are relatively cheap, offering good discounts to their NAVs, paying relatively high distributions and have a solid and substantial past track record in maintaining and growing their NAVs. We adopt a methodical approach to filter down the 500-plus funds into a small subset.

Here is a summary of our primary goals:

  • Reasonably high income/distributions.
  • High long-term performance in terms of total return on NAV.
  • Cheaper valuation at the time of buy, determined by the "excess" discount offered compared to their past history.

A well-diversified CEF portfolio should at least consist of ten CEFs or more, preferably from different asset classes. It is also advisable to build the portfolio over a period of time, rather than invest in one lump-sum. If you were to invest in one CEF every month, in a year, you would have a well-diversified CEF portfolio. What we provide here every month is a list of five probable candidates for further research. We think a CEF portfolio can be an important component in the overall portfolio strategy. One should preferably have a DGI portfolio as the foundation, and the CEF portfolio could be used to boost the income level to the desired level. How much should one allocate to CEFs? Each investor needs to answer this question himself/herself based on the personal situation and factors like the size of the portfolio, income needs, risk-appetite, or risk tolerance.

Selection Process

We have more than 500 CEF funds to choose from, which come from different asset-classes like equity, preferred stocks, mortgage bonds, govt. and corporate bonds, energy MLPs, utilities, and municipal income. Just like in other life situations, even though the broader choice is always good, but it does make it more difficult to make a final selection. The first thing we want to do is to shorten this list of 500 CEFs to a more manageable subset of around 100 funds. We can apply some criteria to shorten our list, but the criteria need to be broad and loose enough at this stage to keep all the potentially good candidates. Also, the criteria that we build should revolve around our original goals.

Criteria to Shortlist:

Criteria

Brings down the number of funds to..

Reason for the Criteria

Baseline expense < 2.0% and Avg. Daily Volume > 100,000

Approx. 435 Funds

We do not want funds that charge excessive fees. Also, we want funds that have fair liquidity.

Market-capitalization > 100 Million

Approx. 400 Funds

We do not want funds that are too small.

Track record/ History longer than 10 years (inception date 2007 or earlier)

Approx. 300 Funds

We want funds that have a long track record.

UNII* Balance > -$2.00

Approx. 280 Funds

A large UNII (Undistributed Net Investment Income) negative balance would indicate that that fund is having problems paying its distributions.

Discount/Premium < +5%

Approx. 250 Funds

We do not want to pay too high a premium; in fact, we want bigger discounts.

Since Inception Annualized Return on NAV > 0%

And 5-Year Annualized Return on NAV > -5%

Approx. 230 Funds

We want funds that have a reasonably good past track record in maintaining their NAVs.

Distribution (dividend) Rate > 5%

Approx. 130 Funds

The current distribution (income) to be reasonably high.

After we applied the above criteria this month, we were left with 129 funds in our list, which is still too long to present here or meaningfully make a selection of five funds.

Narrowing Down to 40 Funds

To bring down the number of funds to a more manageable number, we will shortlist 10 funds based on each of the following criteria. Thereafter, we will apply certain qualitative criteria on each fund and rank them to select the top 5.

Four broad criteria:

  • Excess Discount/Premium (explained below)
  • Distribution rate
  • Return on NAV since inception (long term over 10 years)
  • Return on NAV last 5-years (medium term over 5 years).

Excess Discount/Premium:

We certainly like funds that are offering large discounts (not premiums) to their NAVs. But sometimes, we may consider paying near zero or a small premium if the fund is great otherwise. So what is important is to see the "excess discount/premium" and may not be the absolute value. We want to see the discount (or premium) on a relative basis to their past record say 52-week average.

By subtracting the 52-week average discount/premium from the current discount/premium will give us the excess discount/premium. For example, if the fund has the current discount of -5% but the 52-week average was +1.5% (premium), the excess discount/premium would be -6.5%.

Excess Discount/Premium = Current Discount/Premium (Minus) 52-Wk Avg. Discount/ Premium

So what is the difference between the 12-month Z-score and this measurement of Excess Discount/Premium? The two measurements are quite similar, maybe with a subtle difference. The 12-month Z-score would indicate how expensive (or cheap) the CEF is in comparison to the 12-months period. Z-score also takes into account the standard deviation of the discount/premium. Our measurement (excess discount/premium) simply compares the current valuation with the last 12-months average.

We sort our list (of 129 funds) on the excess discount/premium in descending order. For this criterion, the lower the value, the better it is. So we select the top 10 funds (most negative values) from this sorted list.

(All data as of 05/24/2019)

TICKER

Excess Disc/ Prem

Leverage %

Baseline Expense

Distrib. Rate

Distrib. Freq.

Discount/ Premium

RTN on NAV since Inception

Inception Date

NCV

-7.41%

33.40%

1.33%

11.27%

M

2.01%

7.04%

3/31/2003

ETW

-6.32%

--

1.09%

9.11%

M

-4.87%

5.59%

9/28/2005

CHY

-4.94%

34.54%

1.28%

9.58%

M

-3.36%

8.05%

5/30/2003

NCZ

-4.75%

29.95%

1.37%

10.80%

M

1.83%

6.07%

7/31/2003

BME

-4.52%

--

1.12%

6.51%

M

0.27%

12.22%

3/28/2005

CHI

-3.92%

34.58%

1.29%

9.50%

M

-3.53%

9.29%

6/28/2002

ASG

-3.22%

0.86%

1.28%

8.68%

Q

-4.33%

6.58%

3/14/1986

OIA

-2.88%

19.75%

0.81%

5.24%

M

-0.92%

5.07%

9/19/1988

QQQX

-2.67%

--

0.92%

7.13%

Q

-0.18%

10.08%

1/30/2007

HQL

-2.30%

--

1.19%

8.98%

Q

-8.08%

9.02%

5/8/1992

High Current Distribution Rate:

We sort our list (of 129 funds) on current distribution rate. We select the top 10 funds from this sorted list.

TICKER

Excess Disc/ Prem

Leverage %

Baseline Expense

Distrib. Rate

Distrib. Freq.

Discount/ Premium

RTN on NAV since Incep.

Inception Date

IIF

0.38%

--

1.35%

14.27%

S

-11.38%

9.16%

2/25/1994

IFN

1.69%

--

1.29%

11.53%

Q

-9.85%

8.68%

2/23/1994

TDF

1.90%

--

1.31%

11.49%

S

-10.03%

9.10%

9/8/1994

NCV

-7.41%

33.40%

1.33%

11.27%

M

2.01%

7.04%

3/31/2003

SPE

-0.56%

32.19%

1.91%

11.11%

A

-12.22%

5.87%

6/8/1993

GGT

0.31%

10.36%

1.59%

11.06%

Q

3.04%

7.69%

11/15/1994

IAF

-2.15%

--

1.45%

11.05%

Q

-6.70%

6.94%

12/12/1985

USA

1.91%

0.00%

1.00%

11.04%

Q

-3.90%

8.05%

10/31/1986

NCZ

-4.75%

29.95%

1.37%

10.80%

M

1.83%

6.07%

7/31/2003

FTF

1.22%

25.50%

1.22%

10.73%

M

-6.53%

5.66%

8/27/2003

Long term Return on NAV (since inception, over 10 years)

We then sort our list (of 129 funds) on the Return on NAV (since Inception) and select the top 10 funds.

TICKER

Excess Disc/ Prem

Leverage %

Baseline Expense

Distrib. Rate

Distrib. Freq.

Discount/ Premium

RTN on NAV since Incep.

Inception Date

CAF

1.11%

--

1.72%

8.48%

A

-11.91%

12.81%

9/28/2006

BME

-4.52%

--

1.12%

6.51%

M

0.27%

12.22%

3/28/2005

UTG

3.52%

22.36%

1.10%

5.90%

M

-0.35%

11.37%

2/24/2004

BTO

-1.96%

18.11%

1.62%

6.89%

Q

-2.48%

11.03%

8/18/1994

EMF

1.28%

--

1.33%

5.53%

A

-10.75%

10.88%

2/27/1987

HQH

0.27%

--

1.03%

9.07%

Q

-9.28%

10.78%

4/23/1987

AWF

2.49%

2.55%

0.99%

6.72%

M

-9.72%

10.54%

7/28/1993

RFI

2.44%

0.00%

0.88%

7.11%

M

-0.88%

10.13%

9/27/1993

QQQX

-2.67%

--

0.92%

7.13%

Q

-0.18%

10.08%

1/30/2007

HTD

2.20%

33.19%

1.21%

6.65%

M

-4.08%

9.88%

2/27/2004

Medium Term Return on NAV (last 5-years)

We then sort our list (of 129 funds) on the Return on NAV (last 5-years) and select the top 10 funds.

TICKER

Excess Disc/ Prem

Leverage %

Baseline Expense

Distrib. Rate

Distrib. Freq.

Discount/ Premium

RTN on NAV since Incep.

RTN on NAV last 5-Yrs.

Inception Date

CAF

1.11%

--

1.72%

8.48%

A

-11.91%

12.81%

14.68%

9/28/2006

ASG

-3.22%

0.86%

1.28%

8.68%

Q

-4.33%

6.58%

11.87%

3/14/1986

BTO

-1.96%

18.11%

1.62%

6.89%

Q

-2.48%

11.03%

11.85%

8/18/1994

BME

-4.52%

--

1.12%

6.51%

M

0.27%

12.22%

11.75%

3/28/2005

QQQX

-2.67%

--

0.92%

7.13%

Q

-0.18%

10.08%

10.80%

1/30/2007

RQI

3.31%

26.43%

1.32%

7.14%

M

-4.27%

9.47%

10.36%

2/28/2002

UTG

3.52%

22.36%

1.10%

5.90%

M

-0.35%

11.37%

10.25%

2/24/2004

EOS

1.44%

--

1.09%

7.19%

M

2.36%

7.90%

10.25%

1/26/2005

HTD

2.20%

33.19%

1.21%

6.65%

M

-4.08%

9.88%

10.24%

2/27/2004

RNP

1.73%

26.92%

1.05%

7.11%

M

-9.15%

9.00%

9.72%

6/27/2003

Now, we have 40 funds in total from the above selections. We will see if there are any duplicates from the above selections. In our current list of 40 funds, there are 11 duplicates, so once we remove the duplicate rows, we are left with 29 funds.

Final Step: Narrowing Down to Just 5 Funds

In our list of 29 funds, we already have some of the best probable candidates. However, so far, they have been selected based on one single criterion that each of them may be good at. That’s not nearly enough. So, we will apply a combination of criteria by applying weights to six factors and filter out the best ones.

We will apply weights (from 0 to 10) to each of the SIX criteria:

  • Current distribution rate
  • Current discount/premium
  • Excess discount/premium
  • NAV return since inception
  • NAV return last 5-years
  • Excess NAV return over distribution rate (can be positive or negative)

Once we have calculated the weights, we combine them to calculate an “Overall Total Weight.” The sorted list of 29 funds on the combined weight is presented below. The top five funds are highlighted.

TICKER

Distrib. Rate

Discount/ Premium

Excess Disc/ Prem

RTN ON NAV since Incep.

RTN on NAV last 5-Years

Combined Weight

WT. Distrib. Rate

WT. Dis/Prem

WT. Excess Return

WT. NAV Ret Incep.

WT. NAV RTN 5-Yr

WT. Excess Return over Distr.

CAF

8.48%

-11.91%

1.11%

12.81%

14.68%

41.70

8.48

10.00

-1.11

10.00

10.00

4.33

BME

6.51%

0.27%

-4.52%

12.22%

11.75%

36.47

6.51

-0.27

4.52

10.00

10.00

5.71

BTO

6.89%

-2.48%

-1.96%

11.03%

11.85%

35.47

6.89

2.48

1.96

10.00

10.00

4.14

RNP

7.11%

-9.15%

1.73%

9.00%

9.72%

35.14

7.11

9.15

-1.73

9.00

9.72

1.89

HQL

8.98%

-8.08%

-2.30%

9.02%

6.61%

35.03

8.98

8.08

2.30

9.02

6.61

0.04

HQH

9.07%

-9.28%

0.27%

10.78%

4.53%

34.32

9.07

9.28

-0.27

10.00

4.53

1.71

QQQX

7.13%

-0.18%

-2.67%

10.08%

10.80%

32.93

7.13

0.18

2.67

10.00

10.00

2.95

AWF

6.72%

-9.72%

2.49%

10.54%

4.36%

32.13

6.72

9.72

-2.49

10.00

4.36

3.82

EMF

5.53%

-10.75%

1.28%

10.88%

2.07%

31.67

5.53

10.00

-1.28

10.00

2.07

5.35

HTD

6.65%

-4.08%

2.20%

9.88%

10.24%

31.64

6.65

4.08

-2.20

9.88

10.00

3.23

IFN

11.53%

-9.85%

1.69%

8.68%

7.18%

31.17

10.00

9.85

-1.69

8.68

7.18

-2.85

ASG

8.68%

-4.33%

-3.22%

6.58%

11.87%

30.71

8.68

4.33

3.22

6.58

10.00

-2.10

CHI

9.50%

-3.53%

-3.92%

9.29%

4.65%

30.68

9.50

3.53

3.92

9.29

4.65

-0.21

TDF

11.49%

-10.03%

1.90%

9.10%

5.40%

30.21

10.00

10.00

-1.90

9.10

5.40

-2.39

IIF

14.27%

-11.38%

0.38%

9.16%

6.52%

30.19

10.00

10.00

-0.38

9.16

6.52

-5.11

RQI

7.14%

-4.27%

3.31%

9.47%

10.36%

29.90

7.14

4.27

-3.31

9.47

10.00

2.33

CHY

9.58%

-3.36%

-4.94%

8.05%

4.52%

28.92

9.58

3.36

4.94

8.05

4.52

-1.53

UTG

5.90%

-0.35%

3.52%

11.37%

10.25%

28.20

5.90

0.35

-3.52

10.00

10.00

5.47

RFI

7.11%

-0.88%

2.44%

10.13%

8.67%

27.24

7.11

0.88

-2.44

10.00

8.67

3.02

ETW

9.11%

-4.87%

-6.32%

5.59%

4.46%

26.83

9.11

4.87

6.32

5.59

4.46

-3.52

SPE

11.11%

-12.22%

-0.56%

5.87%

4.64%

25.83

10.00

10.00

0.56

5.87

4.64

-5.24

USA

11.04%

-3.90%

1.91%

8.05%

8.19%

25.24

10.00

3.90

-1.91

8.05

8.19

-2.99

IAF

11.05%

-6.70%

-2.15%

6.94%

1.81%

23.49

10.00

6.70

2.15

6.94

1.81

-4.11

EOS

7.19%

2.36%

1.44%

7.90%

10.25%

22.00

7.19

-2.36

-1.44

7.90

10.00

0.71

OIA

5.24%

-0.92%

-2.88%

5.07%

6.24%

20.18

5.24

0.92

2.88

5.07

6.24

-0.17

NCV

11.27%

2.01%

-7.41%

7.04%

1.65%

19.86

10.00

-2.01

7.41

7.04

1.65

-4.23

FTF

10.73%

-6.53%

1.22%

5.66%

1.33%

17.23

10.00

6.53

-1.22

5.66

1.33

-5.07

NCZ

10.80%

1.83%

-4.75%

6.07%

1.65%

15.91

10.00

-1.83

4.75

6.07

1.65

-4.73

GGT

11.06%

3.04%

0.31%

7.69%

4.55%

15.52

10.00

-3.04

-0.31

7.69

4.55

-3.37

Final List

According to our rankings, the above-selected funds appeared at positions 1, 2, 3, 4, and 8. There are 3 Healthcare funds (BME, HQL, and HQH) in our top positions, so we will need to select only one of them. In this case, we selected the first one at the top, BME.

(Data as of May 24, 2019.)

Ticker

CAF

BME

BTO

RNP

QQQX

AVERAGE of 5 Funds

INCEPTION-DATE

9/28/2006

3/28/2005

8/18/1994

6/27/2003

1/30/2007

CATEGORY

China 'A' Shares

Health/ Biotech

Financials

REITs/ Preferreds

Nasdaq100 -Covered Call

Average of 5 Funds

DISTRIBUTION. FREQ.

A

M

Q

M

Q

EFFECTIVE LEVERAGE %

--

--

18.11%

26.92%

--

9.01%

BASELINE EXPENSE

1.72%

1.12%

1.62%

1.05%

0.92%

1.29%

DISTRIBUTION RATE

8.48%

6.51%

6.89%

7.11%

7.13%

7.22%

DISCOUNT / PREMIUM

-11.91%

0.27%

-2.48%

-9.15%

-0.18%

-4.69%

MARKET CAP

$447 MM

$346 MM

$596 MM

$996 MM

$824 MM

642 MM

UNII BALANCE

0.05

-1.20

-0.54

-0.24

-0.83

-0.55

52 WK AVG Discount/Premium

-13.02%

4.79%

-0.52%

-10.88%

2.49%

-3.43%

Z-SCORE- 3 MONTH

-1.60

-2.70

-2.30

0.50

-1.20

-1.46

Z-SCORE- 6 MONTH

-0.10

-1.90

-1.10

0.80

-0.60

-0.58

Z-SCORE - 1 YEAR

0.40

-2.00

-0.90

1.10

-0.50

-0.38

5 YEAR ANNUALIZED RTN ON NAV

14.68%

11.75%

11.85%

9.72%

10.80%

11.76%

10 YEAR ANNUALIZED RTN ON NAV

8.49%

14.99%

14.22%

20.01%

14.86%

14.51%

ANNUALIZED RTN ON NAV Since Inception

12.81%

12.22%

11.03%

9.00%

10.08%

11.03%

Risks:

It goes without saying that CEFs, in general, have some additional risks that the investor needs to be aware of.

  • Leverage and high-fees:

They generally use some amount of leverage, which adds to the risk. While the leverage can be hugely beneficial in good times but can be detrimental during tough times. The leverage also causes higher fees because of the interest expense in addition to the baseline expense. In the tables above, we have used the baseline expense only. Please note that two of our selections this month do not use leverage at all, and the other two use very low leverage. However, if a fund is using significant leverage, we want to make sure that the leverage is used effectively by the management team - the best way to know this is to look at the long term returns on the NAV. NAV is the “Net Asset Value” of the fund after counting all expenses and after paying the distributions. So if a fund is paying high distributions and maintaining or growing its NAV over time, it should bode well for its investors.

  • Volatility:

Due to leverage, the market prices of CEFs can be more volatile, as they can go from premium pricing to discount pricing (and vice versa) in a relatively short period of time. Especially during corrections, the market prices can drop much faster than the NAV (the underlying assets). Investors who do not have an appetite for higher volatility should generally stay away from CEFs or at least avoid the leveraged CEFs.

  • Premium over NAVs:

CEFs have market prices which are different from their NAVs (Net Asset Values). They can trade either at discounts or at premiums to their NAVs. Generally, we should stay away from paying any significant premiums over the NAV prices unless there are some very compelling reasons.

  • Asset-specific risk:

Another risk factor may come from asset concentration risk. There are many funds that may hold similar underlying assets. However, this is easy to mitigate by diversifying into different types of CEFs ranging from equity, equity covered calls, preferred stocks, mortgage bonds, government and corporate bonds, energy MLPs, utilities, and municipal income.

Conclusion

The underlying purpose of this exercise is to find 5 likely best funds for investment each month, using the screening process. Please note that these selections are dynamic in nature and can change from month to month (or even week to week). However, some of the funds can repeat from month to month if they remain attractive. The selected five CEFs this month, as a group, are offering an average distribution rate of 7.22% and an average discount of 4.69%.

Nonetheless, the underlying purpose is to shortlist and highlight a group of funds that have a solid long-term record, offer high distribution rate and are relatively cheaper and offering a better discount/premium in comparison to their 52-week average. Also, we have tried to pay attention not to allow duplicity in asset-classes among the five funds and have selected them from a diverse group. So we believe that this group makes an excellent watch list for further research.

Disclosure: I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, IIF, CHI, JPS, JPC, TLT.. 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: Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. The author is not a financial advisor. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. The stock portfolios presented here are model portfolios for demonstration purposes.