- STK invests in tech stocks while employing a call-selling strategy to generate income.
- The fund has underperformed its sector benchmark this year considering the extreme market volatility and specific portfolio exposure.
- The combination of an unimpressive returns history, a wide premium to NAV, and our cautious outlook on the market keeps us from recommending this fund.
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The Columbia Seligman Premium Tech Growth Fund (NYSE:STK) is a closed-end fund (CEF) that invests in technology sector stocks. The fund utilizes an options selling strategy that supports its managed distribution policy that currently yields 9.2%, making STK an interesting vehicle for income-focused investors. That being said, we highlight a relatively poor performance history with the fund lagging its benchmark this year, potentially exposing some weaknesses in the strategy and the portfolio allocation. We recommend investors avoid STK in the context of our overall cautious market outlook as risks are tilted to the downside.
STK Strategy Background
STK is actively managed, meaning the portfolio holdings are not meant to track any particular index. The strategy focuses on growth tech stocks and uses the NASDAQ-100 (QQQ) to employ a rules-based call option writing strategy. By selling calls on the index, the fund collects the options' premium which generates income and also represents a partial hedge against a market move lower. All else equal, a call writing strategy will tend to underperform in a strong bull market while it should limit losses on the way down.
STK adjusts the level of call selling and coverage ratio following the volatility level of NASDAQ-100 based on the 'VXN Index.' In an environment of low volatility with the VXN Index at a level of 17 or lower, the aggregate notional amount of written call options as a percentage of the fund's equity holdings is kept at 25%. At higher VXN index levels, the fund's rules dictate increased call selling up to 90% of the stock exposure value.
(Source: Columbia Seligman)
This is important considering the NASDAQ-100 this year experienced extreme levels of volatility with the VXN index reaching a high of 80 in March. Indeed, with official fund data through March 31st, STK had 89.9% of the fund's value covered with the "over-write" strategy.
Essentially, the fund takes a more defensive position as volatility rises. The problem, however, is that extreme levels of volatility like what was observed in March oftentimes point to key market reversals. STK was selling calls at least through the end of March, precisely at the time when buying calls or being unhedged to the upside would have been optimal. Since NASDAQ-100 rallied 15% in April, the large call-write position detracted from the fund's performance over the month by limiting upside.
Based on the current VXN level of 36 which has trended lower in recent weeks, STK's rules-based option strategy dictates that it may still have 90% of the aggregate notional values of fund's common stocks hedged with covered calls. This implies the fund is not participating completely during the current rally in tech stocks.
The fund's portfolio holdings are based on the fund manager's market outlook and expectations. STK's largest position as of March 31st was in Lam Research (LRCX) with an 8% weighting. This stock is down 15% year to date and has also dragged the fund's total return this year. Notably, STK is underweight several of the top holdings of QQQ like Microsoft (MSFT), Apple (AAPL) which together represent about 10% of the fund compared to about 23% of QQQ.
(Source: Columbia Seligman)
Separately, STK does not hold shares in Amazon.com, Inc. (AMZN) which has a 10% weighting in QQQ and has been a strong performer, up 26% year to date. These dynamics help explain the underperformance of STK this year against the NASDAQ-100 benchmark. STK is down by 12.3% compared to a 2.9% gain in QQQ in 2020.
We note that STK has had an underwhelming performance history over the past decade on a total return basis to the market price and NAV. We compared the returns for the fund to two-alternate "covered-call"/ overwrite NASDAQ-100 funds and found that STK has been a laggard this year. Year to date, STK is down 14.1% compared to a 2.5% gain in QQQ, an 8% decline in theNuveen Nasdaq 100 Dynamic Overwrite Fund (QQQX) and a 12% loss from the Global X NASDAQ 100 Covered Call ETF (QYLD).
(Source: data by YCharts/table by author)
QQQX is also a CEF but is meant to offer more passive exposure to the index while employing a "dynamic" covered call strategy depending on the portfolio manager's market view. QYLD as an ETF also provides passive exposure to the NASDAQ-100 stocks but maintains a near 100% covered call ratio consistent with the tracking 'CBOE NASDAQ-100 BuyWrite Index.' We are also including the BlackRock Science and Technology Trust (BST) as a comparable CEF for tech sector equity exposure. This fund also invests in healthcare sector stocks but is included here reference purposes as it has been a top performer among equity-CEFs.
STK has underperformed QQQ, QQQX, and BST over the past couple of years. In a 3-year lookback period, QQQ has gained 63% compared to 21% for STK, 24% for QQQX, 86% for BST, and 15.7% for QYLD.
Another disappointment for STK is that the fund management specifically mentions the call-writing strategy as designed to "mitigate downside volatility."
(Source: Seligman Threadneedle)
Shareholders that may have expected the fund to represent a defensive position in the market were in for a surprise when STK presented a drawdown of 40.74% this year at the market low on March 23rd. This compares to QQQ which had a drawdown of 27.9%, while only QYLD ETF in the group was able to provide some downside protection with a slightly lower 23.96% decline.
Wide Premium To NAV
The other consideration here is that STK is currently trading at a historically wide premium to NAV of 9.6%. While the fund has briefly traded at higher premiums over the past decade, the average spread to its net asset value has averaged 2.9% in the past five years. This implies that the fund is expensive as investors have typically been able to acquire shares closer to the underlying value of the portfolio holdings.
It's also a significantly wider spread compared to QQQX at 0.98% and QYLD at just 0.2%. Oftentimes, a higher premium in a CEF can be explained as investors paying up to be invested alongside a star fund manager or if the strategy is performing well; we don't think that's the case here.
Our point is that it simply adds to one more reason why we are avoiding STK at the current level. Investors interested in STK should wait for an opportunity to pick up shares when and if the fund trades at a discount to NAV. A narrowing of the premium from current levels would drive an incremental loss for shareholders at the market price.
One of the positive aspects of the fund is that it has been able to distribute its quarterly distribution without the use of return of capital payments, also known as "ROC." The payments have been facilitated by the strong market performance which has supported the NAV of the fund during the bull market in tech stocks in recent years. Since 2014, all distributions have been covered through the regular capital gains of the fund's trading activity. Considering the fund's NAV is down 23% year to date in 2020, it becomes increasingly possible that ROC could be necessary later this year.
(Source: Seligman Threadneedle)
Going back to our comparison of STK with comparable funds, the distribution yield of 9.2% is above QQQX's 7.1%, but below QYLD which yields 11.7% as the two alternate "options strategy tech CEFs." Recognizing that each fund features a different strategy, QQQX and QYLD more regularly utilize return of capital payments. BST's 10.7% yield includes a smaller quarterly distribution and a special distribution paid in Q4 of 2019 and 2018. The stated yield on BST's regular distribution is 5.7% and the fund pays monthly.
Analysis and Forward-Looking Commentary
The market rally since the end of March particularly in tech stocks has been impressive. Despite the ongoing coronavirus pandemic and looming worldwide recession, investors are focusing more on the enormous relief efforts between the Fed and government that are expected to support a recovery process. Technology companies are seen as more resilient, considering trends in stay and work from home accelerating a transition to the digital economy.
On the other hand, our concern comes down to valuation as many of the sector leaders are back to trading near all-time highs. The biggest risk we see is the potential for structurally higher unemployment through 2021 pressuring consumer spending and growth trends for tech stocks. We sense that the market is already expensive and is pricing in exuberant best-case-scenarios while the risks are tilted to the downside. Renewed volatility and another leg lower in the stock market can be bearish for tech and the STK fund.
To summarize, the following points keep us away from STK.
- Regular underperformance to the tech sector benchmark.
- Unconvincing stock picking ability by management team considering a large position in Lam Research significantly detracted from performance this year and the fund did not hold Amzon.com which has been a big winner.
- Currently wide premium to NAV suggesting the fund is relatively expensive.
- We think QQQX and BST are better alternatives.
- An overall bearish outlook on the market from current levels considering sharp rally since March lows while risks remain tilted to the downside.
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This article was written by
15 years of professional experience in capital markets and investment management at major financial institutions.
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