Bear Market Thoughts: Is Closed-End Fund Investing 'Chasing Yield?'
Summary
- It's really all about the assets which drives returns.
- Managers can pay out anything they want.
- Were we yield chasing with our MLP and CLO positions? I say no.
- Remember CEF investors, don't just focus on the yield!
- This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Get started today »
Author's note: This article was initially released to CEF/ETF Income Laboratory members on April 6, 2020.
Closed-end funds have taken it on the chin the last two months. Not only are prices and NAVs of funds way down (but price more so than NAV, but that's a topic for another post), but also distribution cuts are likely coming too. Not surprisingly, this brings out the possibly well-meaning but also overly simplistic comments about how CEF investing is "chasing yield". The insinuation is that by only focusing on yield, CEF investors are forgetting about risk.
In this Bear Market Thoughts, I'd like to address the question, "Is Closed-End Fund Investing 'Chasing Yield'?"
Don't just focus on the yield!
It is an unfortunate fact that many CEF investors do in fact "chase yield" while ignoring risk. CEFs are dominated by retail ownership, and it is understandable that many such investors do strongly seek out the ability to receive a high income from their investments. This is, in my opinion, why certain CEFs get bid to massive +50%-plus premiums despite the fact that their performances aren't better compared to their peers at the portfolio level. This type of yield chasing invariably does not end well. When the inevitable distribution cut occurs, the premium (and share price) usually collapses, saddling the investor with capital losses equivalent to many years of distributions (see Why CEF Distribution Stability Is Overvalued).
On the other hand, at the CEF/ETF Income Laboratory, one of our favorite sayings is "remember CEF investors, don't just focus on the yield!"
Fun fact, how many times have I mentioned the yield of a fund in the title of an article over the last year? The answer is zero times! In fact, in the nearly four years since starting our newsletter service, and after nearly 1,000 of my own posts, I count only four times (!) where I have mentioned the percentage yield of a CEF in the title (I, II, III, IV). And of these, only one fund (UTG) was even a portfolio holding at all.
Our emphasis on not chasing yield is a primary reason why our Income Generator portfolio experienced zero distribution cuts* in 2019; in fact grew its income by 21% year-on-year without increasing risk (see Why You Shouldn't Just Buy The Highest-Yielding CEFs + How We Grew Our Income By 21% In A Year). In that report, we noted how our portfolios crushed a basket of 30 CEFs with the highest yields from a year ago, many of which experienced distribution cuts over the following year.
(*Unfortunately, this streak is likely coming to an end soon. Nick put out an excellent piece explaining why distribution cuts will occur even for high-quality CEFs during bear markets, do check it out if you haven't done so already! (Bear Market Thoughts: Distribution Cuts).
Moreover, analyzing the fundamentals has allowed us to call many CEF distribution cuts at the Income Laboratory over the years, allowing our members to sidestep the dreaded cut announcement that often whacks the share price hard leading to substantial losses.
Finally, when we execute our portfolio swaps to get "free shares" of our funds, we don't take yield into consideration much, if at all. This always makes some members happy when the fund that we swap to has a higher yield, and vice versa. However, the yield difference actually isn't too important, and we'll see the reason for this below.
It's all about the assets
Newer members may wonder: why don't we place a greater emphasis on the yield of a fund? We are the CEF/ETF Income Laboratory after all.
The answer is that it's all about the assets. Remember, CEFs are not a separate asset class! They are simply an investment vehicle, or "wrapper" for a particular set of assets. (See Income Lab Ideas: Asset Classes And Portfolio Allocations)
When a group of funds are investing in the same sector, we'd expect them to all "earn" (whether from dividends, income, or capital appreciation) a similar rate of return from their assets. However, because CEFs often pay out return-of-capital ("ROC") distributions as part of their managed distribution programs, the actual yields exhibited by funds from the same sector can vary. The simple truth is that a fund manager can basically choose to pay out as much yield as they want without restriction.
What this means is that, when we're looking at funds from the same sector, what one fund lacks in the yield department is made up for by better capital stability and returns. Conversely, a higher-yielding fund would be expected to show weaker capital sustainability.
This is a point that unfortunately trips up a lot of newer CEF investors. This is not helped by those financial authors who put out click-bait headlines such as "how to earn an 8% yield from S&P 500 stocks", as if there is some kind of magical free lunch available when SPY is yielding only ~2%. Investors who do not understand how the yield of certain CEFs are generated are frequently disappointed when they find that share price of their fund has not kept up with the capital appreciation of the index.
The principle that it's primarily about the assets (rather than the yield) that drives returns is easily validated by considering the recent performance of the US general equity CEFs from the database. Three months ago, these yielded between 1% (for GAM) and a whopping 22% (for CLM/CRF). However, there was little correlation between their yields to their NAV total returns during the market sell-off over the following months. In fact, their average three-month NAV total returns (-23%) closely matched SPY (also -23%). This shows that the headline yield of the funds had an insignificant effect on their subsequent performance, as expected.
Of course there may also be some differences in yield that arise due to fundamental factors, such as fund leverage or the level of risk taken in the portfolio (e.g. loading up on CCC credits). However, both of these factors also increase the risk/reward of the fund as well (see Postmortem On 13%-Yielding ACP: Don't Just Look At The Yield as an example of a risky fund that has underperformed vs. its peer group). This again means that there's "no free lunch" in terms of having a higher yield vs. the peer group.
We see this playing out a little with the national muni funds over the last three months. Those funds that sported higher yields from three months ago generally showed worse returns during the market sell-off. In particular, CEFs with a high-yield mandate fell especially hard as the liquidity crunch hit those bonds the most. The data is also somewhat skewed by the fact several of the low-yielding funds are term funds due to expire soon, these would be expected to be much less volatile as they may have partially or fully deleveraged and/or are retaining cash in anticipation of the upcoming liquidation event.
MLPs and CLOs
It's no secret that our two worst-performing sectors in our portfolios have been midstream funds and CLO funds. These were also among the highest-yielding sectors, which raises the question: were we "yield chasing"?
The answer, at least from my perspective while I was managing our model portfolios, was no. We were attracted to the midstream sector because of their stable fee revenues, toll-like characteristics and attractive valuations. As we wrote last year in The Best Midstream/MLP CEFs - December 2019 Update (Our Picks Are Still Leading The Pack!):
At the same time however, valuations are undoubtedly attractive and they have continued to get cheaper this year. According to the latest MLP Monthly Report from Global X, we can see that MLP enterprise value to EBITDA valuations continued to move lower this year even while utilities and REIT valuations ground higher. Since the peak of the MLP boom in 2015, MLP valuations have been sliced in half. This is an important point to note - it is not as if earnings in the sector have deteriorated sharply - just their share prices! As a value investor, this is what I like to see.
Besides, we selected our MLP funds not on the basis of yield, but on valuation and quality. The two funds that we had owned for most of the last 1.5 years, FPL (which we swapped for FEI last month) and KMF (which we sold), strongly outperformed the 10 funds that we had identified as having the weakest distribution coverage in the time since we released our December report (so there's no hindsight bias). If you had invested $10,000 in our two picks in December, you would be down to $3,595, a poor result for sure but still more than double the average for the 10 weakest funds ($1,631): MIE, TYG, JMF, NTG, FMO, GER, JMLP, GMZ, CEN, and DSE. I know it's not much consolation right now, but in any other circumstance, we'd be celebrating our fantastic fund-picking results.
In fact, FPL and KMF haven't performed too much worse than the Energy Select Sector ETF (XLE) once the leverage of the funds is taken into account. This indicates that the poor (but still sector-leading) performance of our MLP positions could be largely attributed to the twin black swans of the oil price collapse and COVID-19 pandemic. (And not necessarily due to inherent defects of the MLP CEF structure).
Were we aware that the MLP funds were risky? Sure, this is why [i] they had a risk rating of "9" in our portfolio sheets, [ii] they were only included in our more aggressive Tactical Income-100 portfolio, and [iii] they only had small weights of around 2% each. Those funds were bad investments no doubt, but they weren't a function of yield chasing.
With CLOs, their strong cash flow characteristics were attractive draws for us as we made our investments in this sector in both our Tactical Income-100 and Income Generator portfolios. While their high payouts did function as nice yield booster, we were not enamored by them. This is especially because our own CLO expert, Alpha Male, had been warning (see here and here) that these funds were not covering their distributions by net investment income according to GAAP metrics, and that the high premium valuations of these funds were not deserved. This led us to trim ECC twice in our Income Generator portfolio (at $18.16 and at $16.93) in 2019, and we did not add any net CLO equity exposure in either portfolio last year.
In hindsight, we should have sold our CLO positions completely once the coronavirus started hitting American shores, even though they were already down around -20% by then. It was only in the middle of March was the full extent of economic disruption due to the lockdown made clear, and by then it was too late to sell (in my opinion).
Nevertheless, we have frequently mentioned in our writings that CLOs are a highly risky and volatile sector. We have also previously warned that the CLO equity funds were not covering their yields by NII, and that the high premium valuations that they reached last year were undeserved. In fact, up until the beginning of March 2020, Eagle Point Credit Company and Oxford Lane Capital Corp (OXLC) were still marked with a "HOLD/SELL" rating in our portfolio sheets; the only two positions in our Income Generator portfolio to display that rating at the time.
Finally, we have never claimed that CLOs would hold up well in a recession (quite the contrary in fact, at least with regards to their share prices!). Therefore, I do not think that we were "yield-chasing" and ignoring risks with these investments. Rather, we miscalculated the effect of the pandemic and were also too slow to react to rapidly changing circumstances. We also rated the risk of these positions a bit too low and were in hindsight too overweight in this sector.
What to do now? At these low prices, it doesn't make much sense to sell them now (in my opinion), but we are fully aware that distributions are going to be reduced and that there is no guarantee that prices won't go any other. Our latest missive from our CLO expert, Alpha Male, is of course essential reading for those who are still holding onto these investments: The Upcoming Events In The CLO CEF World.
Summary
While higher yield does generally equal higher risk, the situation isn't so black-and-white with closed-end funds. For one thing, CEF managers can choose to pay out any amount of yield that they want, but the total return is still going to be driven by the underlying assets. For example, the ~20%-yielding CLM/CRF had similar NAV returns to the ~2%-yielding SPY during the latest crash. Ten times the yield but the same risk? This is practically unheard of outside of the CEF world!
Here's another example, the ~10%-yielding Cohen & Steers Total Return Realty Fund (RFI) versus the ~5%-yielding Vanguard REIT ETF (VNQ). RFI has twice the yield of the benchmark, but drawdowns were very similar at the NAV level!
RFI has also done way better than the eight 10%-yielding REITs mentioned in this article: 8 REITs With 10% Yields, even on a total return price basis, which greatly disadvantages the CEF because of the widening discount over this time period.
Ultimately, it's the assets that a CEF owns that drives returns. After deciding on sector exposure, look for management quality, historical performance, premium/discount valuation and the sustainability of the distribution. Here, our mistake for our portfolios was remaining in the MLP and CLO sectors overlong, rather than yield chasing per se. The fact that markets collapsed within the shortest time in history certainly didn't help.
But yet, just because we don't practice yield-chasing for our portfolios doesn't mean that it is not possible to yield-chase CEFs. We've seen time and time again how high-yielding CEFs are bid up to stratospheric premiums, only for that (and the share price) to collapse once the inevitable distribution cut arises. We've called many of these for Income Laboratory members over the past several years. Remember CEF investors, don't just focus on the yield!
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This article was written by
Stanford Chemist is a scientific researcher by training. For the past decade he has been providing analysis and evidence-based ways of generating profitable investments with CEFs and ETFs. He leads the investing group Learn more.
Analyst’s Disclosure: I am/we are long THE STOCKS IN OUR PREMIUM PORTFOLIOS. 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.
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Comments (34)
Rich
...Power Rating: 96 [must be higher than RptCard grade for any further buy consideration]..Star Rating: Positive 9star [0-10star reference with 10 being the max]
...!3-wk Star Rating: Positive 9.71 stars
...MktPrc: 9.27 [COB Friday]
...Last average weeks market activity on MktPrc: +0.03 [investors have been buying]
...Distribution [not a dividend]: 24.12% [$0.1853/Month ... $2.2236/Yr]
Note: x-div's 5/13, 6/13 ... Pay 5/29, 6/30
...Insider buying: 3/27 30,000sh @ 8.25
...Rf [risk factor for holding in portfolio]: Positive +0.534 [0-1.500 range for analysis evaluation]...NAV: 9.02 [COB Friday] ...
...Discount: slightly negative -0.97 [0.03 below norm] COB Friday...Total analysis numb3rs: 1674/2548 [require 1600/2500 for buying activity]
Note: Normal trading range for CEF's are 1000/1400 ....Bottom Line:
1... Remains a very good CEF for current "Income oriented" portfolio's if bought between 8.75 to 9.50 [and does not exceed 0-2% (for conservative income investors)] of total portfolio in the current timeframe....
2... Some very good CEF's exist currently and should be looked at and individually analyzed [>12% distributions with increasing MktPrc's for potential CapGains]....
3... Market remains "volatile" and a normal "buy/hold forever" is not in the cards currently as "computer traders" are in/out in microseconds. Add to this that CEF's trade with extremely low "Volume" and can move MktPrc's radically....Disclosure: Some of us currently hold >6% currently [only 6% maximum for any one single CEF is allowable]....Have a "GREAT" week....
Live Long and Prosper....
Best Regards/Eddie....
Your articles seem to be the ones I keep finding and reading on SA. I find them to be the most informative and make the most sense. I also appreciate the patience in your responses. You think twice before you respond and always provide a measured response even to the most irritating posts.
CLO prices reflecting just a fraction of likely defaults, UBS says https://t.co/NgmbDneeIn via @Markets