How To Think About Seasonality Of Your CEF Portfolio

by: ADS Analytics
Summary

Major asset classes like stocks and Treasuries have clear historic patterns of returns across the year.

This pattern of returns is also passed onto CEFs which can magnify or dampen these patterns.

We find that diversified CEF portfolios do not have much NAV seasonality; however, individual sectors do, particularly in price terms, although historic dispersion is high.

We think investors who run more concentrated portfolios should revisit the valuations of their investments to see whether allocating to cash makes sense.

Relatively rich macro CEF valuations with tight yield spreads to cash presents an opportunity to derisk at the margin, particularly with volatility set to remain high for the rest of the year.

Most investors are familiar with seasonality claims like 'sell in May and go away' as well as regular periodic phenomena like December tax-loss harvesting and the 'January Effect'. Most of the time these claims are discussed in reference to major asset classes such as equities. In this article, we take a look at whether CEF sectors exhibit any seasonality and what it means for investor portfolios.

We find that in aggregate, sector NAVs do not have much historic seasonality, so investors who are diversified across CEF sectors and who are happy to ride out periodic volatility in discounts can ignore seasonality.

Individual sectors, however, do exhibit seasonality, particularly in price terms. However, because of high dispersion, historical seasonality trends alone are not a robust predictor of forward returns. We, therefore, recommend that investors who run more concentrated portfolios revisit the valuations of their investments to see whether allocating to cash at the margin makes sense. Given very tight CEF yield spreads to cash and with volatility set to remain high, we think short-duration alternatives present an attractive option as a way to boost the reserve of 'dry powder'.

How Do CEF Features Impact Asset Seasonality?

Closed-end funds are directly impacted by the seasonality of their underlying assets. However, various features of CEFs also can further support or dampen these effects. What are these features?

  • Extrapolating seasonality trends to closed-end funds are complicated for three structural reasons. First, CEF sectors range across different asset classes. Secondly, individual funds can allocate across asset classes. Thirdly, CEFs are traded as common shares of investment companies and, therefore, behave as a mix of stocks and the fund's underlying assets.
  • Bond seasonality sometimes supports or offsets stock seasonality.

S&P 500 vs US 10Y

  • CEFs often incorporate leverage which can magnify any seasonality in the underlying assets.
  • CEFs have relatively high distribution rates which can make waiting out seasonality more expensive.
  • Apart from the seasonality in NAV which is linked to the underlying stock/bond seasonality, CEFs have a seasonality in discounts which is linked less to the underlying assets and more to stocks and broad-market volatility.

All of these moving parts make for a confusing picture; so, in this article, we take a brief deep-dive into CEF seasonality.

CEF Market Seasonality

There are many ways we can slice and dice CEF sector returns - price vs. NAV, median vs. mean, AUM, or equally-weighted.

Let's have a look at the simplest analysis we can do - average sector total price returns were for each sector we average total price returns across the months and then average those monthly returns across the sectors. Our analysis is limited to income CEF sectors since the year 2000.

The chart does show an unmistakable dip in performance in the second half of the year with a string of 3 negative months.

Source: ADS Analytics LLC, TIINGO

Now, it's possible that average monthly returns present a somewhat skewed picture because of a limited number of deeply negative returns in the second half of the year, particularly in 2008, 2011, and 2015. Of course, if you are "buy-and-hold", you still earn average rather than median returns; however, it's still worth knowing how much the results are skewed by those few years.

Let's see whether those few years do indeed skew the results and whether median returns look much different.

Source: ADS Analytics LLC, TIINGO

The median returns do indeed look a lot better - consistently higher in the second half than mean returns. That may not be a big help if you've gone through those few particularly nasty sell-offs in the second half of the year, but unless you think that there is something systematic about the increased market vulnerability in the second half of the year, this should provide some comfort.

Prices aren't everything, however - many CEF investors are much more focused on NAVs and are happy to ignore widening discounts, particularly if they are not an indication of permanent capital loss. So, let's have a look at what median NAV returns look like across the months.

Source: ADS Analytics LLC, TIINGO

Median monthly NAV returns averaged across the sectors and shown in orange bars look even better. In fact, you have to squint pretty hard to see a deterioration in performance in the second half of the year.

So, the key takeaway of the last chart is that investors who are reasonably diversified across sectors and who don't care too much about changes in discounts should probably just ignore any historic seasonality.

The value of keeping a diversified portfolio is illustrated in the chart below which plots the average annual trajectory of total returns across the sectors. It's clear from the chart that some sectors tend to appreciate steadily without much pause such as REITs, RMBS, and convertibles while others take a pronounced pause such as loans and high yield.

Source: ADS Analytics LLC, TIINGO

Therefore, for investors who are concentrated in a small number of sectors, the story is not as simple. To illustrate this, let's have a look at the high yield sector which displays much stronger seasonality than the sector average. There is a clear level drop in prices from June till December with consistently unattractive returns. The average or median returns themselves, however, don't tell a complete picture - we need to know how wide the dispersion of returns is around these levels.

Source: ADS Analytics LLC, TIINGO

The chart below shows monthly total price sector returns for each month via box-and-whisker plots which are a fairly intuitive way to picture return dispersion. The chart shows that while median returns (represented by a line through the box in each month) fall in the second half of the year, the historic dispersion around those median returns has been very high. And, in fact, the return dispersion has been higher in the second half of the year than in the first.

Source: ADS Analytics LLC, TIINGO

The takeaway for us here is that even for a sector like high yield which exhibits a clear downtrend in mean and median prices through the second half of the year, it is difficult to make any firm conclusions that rely on seasonality alone.

So, is this all just a long-winded way of saying you should ignore seasonality?

We don't think so. Instead, we think that the less favorable seasonality in the second half of the year for many sectors means investors should do two things: take this opportunity to revisit fund and sector valuations in their portfolio and, to the extent that portfolio valuations are not a slam dunk, ensure there is sufficient investable cash for potential opportunities down the road. The recent volatility around tariff negotiations as well as the last December sell-off are clear examples that the market is likely to remain volatile for the rest of the year.

So, How 'Bout The Valuations

There are a couple of big picture valuation metrics that we like to keep an eye on. They are not a replacement for fund and sector-specific analysis but they do a reasonable job of giving us a quick sense of the overall market.

First is the average CEF sector lifetime z-score. Usually, z-scores are analyzed within a given rolling period, usually 1-year. Such a short period makes it difficult to make a long-term valuation judgment, so for each point in time, we begin the period with the year 2000. The end result here is that CEFs, in aggregate, look pretty pricey on a 5-year horizon but less so going back to 2000.

This lifetime z-score gives us a better sense of where we are relative to history; however, it's not perfect because z-scores are really a function of yields given the relatively tight relationship between discounts and yields.

Source: ADS Analytics LLC, TIINGO

So, to get a better sense of CEF valuation, we think the yield spread to cash metric cuts through much of the noise and really gets to the heart of the matter - how much are CEFs yielding in excess of cash? The result here is much less attractive - you have to go back to the period prior to the financial crisis to find a market environment where CEFs had a smaller pickup relative to cash.

Source: ADS Analytics LLC, TIINGO

This relatively rich valuation of the overall universe does argue for reserving some dry powder at the margins that could be allocated back into the market during periods of heightened volatility.

What could these 'dry powder' investments be? To take a page out of our Cash Chartbook, we see the ETFs and mutual funds in the chart below as viable options. Investors can weigh the risk/reward of each option by the current yield on the y-axis vs. the worst 3-year drawdown on the x-axis.

Source: ADS Analytics LLC, TIINGO.

Conclusion

To come back to our title question, 'should investors worry about CEF seasonality', our answer is 'not really, but...'. A diversified CEF portfolio does not show much historical NAV seasonality. Individual sectors, however, do. Therefore, those investors who run more concentrated portfolios should revisit their allocations, particularly during a period of relatively rich valuations such as the one we are witnessing now. This will allow for timely allocation of dry powder at more attractive levels when markets invariably turn lower.

Disclosure: I am/we are long MINT, SHV, NEAR. 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.