Written by Nick Ackerman, co-produced by Stanford Chemist
The Miller/Howard High Income Equity Fund (HIE) isn't a widely followed closed-end fund. Miller/Howard is a smaller firm founded in 1984. They have less than $4 billion in assets under management. This is partially why no one has probably heard of them. Considering they are contending with fund sponsors with trillions in AUM. The last reported net assets of HIE come in at only around $136 million. However, the fund offers investors opportunities at a large discount and limited term.
The fund is classified as a "diversified, closed-end management investment company whose primary objective is to seek a high level of current income with capital appreciation as a secondary objective."
They intend to invest "at least 80% of its total assets in dividend or distribution paying equity securities of US companies and non-US companies traded on US exchanges. The Fund will seek to invest in securities that the Investment Advisor considers to be financially strong with reliable earnings, high dividend or distribution yields and rising dividend growth. The Fund may invest up to 25% in Master Limited Partnerships (MLPs), generally in the energy sector. The Fund intends to engage in an options writing strategy consisting of writing put options on securities already held in its portfolio or securities that are candidates for inclusion in its portfolio. It may also engage in covered call writing strategies and it may buy put and call options. The Fund may write covered put and call options up to a notional amount of 20% of the Fund’s total assets."
This fund has a lot going on. They have an option writing strategy, and they also utilize leverage on the fund. The larger exposure and focus on dividends/distributions does mean they leaned heavily in the energy space for several years. That has been a struggle, to say the least. Now, it appears they are repositioning their portfolio into other sectors.
The fund last reported that their leverage stood at 19.7% of managed assets. Total net assets come in at around $136 million, this would put total managed assets at around $163.2 million. This was from their information available on their latest Fact Sheet. This does mean they had to delever during the crash experienced in March of 2020. Ultimately, high energy exposure has put significant pressure on the fund's total returns.
With the changed composition of their portfolio and the deep discount on a limited-term fund, this can be a potential for opportunity. The fund has a 10-year term and it launched on November 24th, 2014. This puts the anticipated liquidation date in 2024.
They always leave provisions in for extending the term, this is no different with HIE. With HIE, they leave the door open for an extension of up to one year. As a smaller fund sponsor, I believe the risk could be greater than something like BlackRock or Eaton Vance that might have a "larger" reputation to protect. Though Nuveen has converted term dated funds into perpetual funds in its past, there can be no guarantee that this doesn't happen. In the case of Nuveen, they allowed shareholders to tender 100% of their shares meaning that they could have got out at NAV if they wished.
On both a NAV and share price basis, the fund has suffered quite significant losses for the year. This is a bit of what originally opened up the opportunity to invest in the fund in the first place. They had been positioned relatively heavily in energy. As we know now, that wasn't the greatest mixture heading into 2020 with a pandemic that shuts down the world's economies. Then, even while that was happening - the energy sector got hit further with a Saudi-Russia oil war briefly. This eventually ended up with both sides coming to an agreement about cuts. This has since propelled the price of energy back higher. It wasn't without its damage though.
In fact, energy has been the worst-performing sector in 2014, 2015, 2018 and 2019. Energy is also on track to be the worst-performing sector in 2020. At the moment, they are leading the pack down in the first half of the year. This poor performance is definitely reflected in HIE's performance. For the end of July, their annualized returns were quite a disappointment.
(Source - CEFConnect)
On a YTD basis, this is another area where it was reflected, as the fund had to delever during the market collapse that hindered their recovery.
This poor performance can also explain why the fund is sitting on a discount of 12.23%. Another factor of this is when the fund cut their distribution. This is when the CEF/ETF Income Laboratory took advantage of that move. We added the position to our Tactical Income - 100 portfolio. This portfolio is designed to take advantage of special situations and be more aggressive overall.
(Source - CEFConnect)
The cut in distribution and poor performance in March led to a sharp increase in the fund's discount. With about 4 years left in the fund's term, the fund could just remain flat and there could be a potential to earn ~4% alpha. Stanford Chemist has highlighted this opportunity previously, and it still remains today.
The fund cut its distribution by 65.5% in April. Even after that slash, the rate was over 9%. That is certainly attractive for most income investors. Currently, the fund pays out a monthly distribution of $0.04. This is good for a still attractive 7.35% rate. For the NAV distribution rate, it is much more manageable at this time at 6.45%. Many investors became quite attracted to the previous distribution as it was maintained since 2015. This is partially what was responsible for the fund beginning to trade to premium levels, as seen above.
(Source - CEFConnect)
The fund did, and still does to a lesser extend, hold MLPs in its portfolio. This generally leads to return of capital being classified in a fund's distribution.
(Source - Annual Report)
For HIE, we see that they have distributed out ROC in their distributions for each of the past two years. In 2019, this wouldn't be considered destructive as the NAV grew a bit throughout the year.
(Source - Semi-Annual Report)
From their latest report, for the period ending April 30th, 2020. We do see that net investment income did decrease on an annualized basis. This wouldn't have been from dividend cuts alone, as it will take a bit of time before we see the real damage of dividend cuts on many funds. The expenses of the fund haven't also increased either. That tells us that it comes down to mostly portfolio turnover. Taking on positions that are paying less in dividends. As an equity fund, it isn't necessary to fund the distribution 100% from NII. The fund can still utilize capital gains and possibly still grow its NAV as well.
Another area of interest to note is that the fund isn't trading at premium levels anymore. That being the case, they won't be able to issue shares in their ATM offering. This could potentially put more pressure on the fund's assets as well where they could previously "grow" the fund through those means. This also included, to a lesser degree, the growth of the assets managed in relation to their dividend reinvestments.
The fund is also sitting on a deficit of unrealized depreciation of almost $19 million. Those losses can be used to offset future gains for tax purposes. However, it is also another factor in that they clearly needed to cut the distribution level as it was unsustainable. Without any gains to rely on, they would have been reducing assets.
(Source - Fact Sheet)
The fund is still positioned with around 17% in the energy sector. However, this is far from where they were at the end of last year. They have a pretty high turnover, the annual average for the past 5 years is 98.6%. According to their Annual Report for the period ending October 31st, 2019. The fund had around 40.9% allocated to energy. This was primarily in the "natural gas transmission" subsector. That came out at 18.7%. Heading into 2020, that was quite the wrong place to be.
However, I am more inclined to feel positive about how they might be able to perform going forward with their change in assets now favoring financials. It is true, it is a "value" area of the market. I believe though that financials are in a position to really turn around when we can get the economy back on track. This does mean that a treatment or vaccine might need to be widely available. This would allow businesses to go back to a more normal state, getting rid of the current regulations that have been instated.
The other area of interest in the portfolio I believe comes from the tech positioning and utility sector exposure. Tech has certainly performed very well, leading the markets higher throughout 2020. Utilities though have also been quite a dog for most of 2020. They come in at about the middle of the pack as far as sector performance is concerned. This also means their valuations have come down from 2019's valuations, where some feel they had begun to get stretched. Since 2019 was such a strong year anyway, this was what hindered utilities to play their usual role as the defensive place to shelter assets. However, back to better valuations and they might be able to play that role again.
(Source - Fact Sheet)
It is important to consider that as active as a portfolio that HIE runs, these positions might change frequently. One of the first positions that caught my attention is BP plc (BP). That company just cut its dividend in half. That still puts the dividend yield at 5.7%, which is quite a respectful yield for a company. After the cut, the share price actually bounced higher. Sending the current dividend yield to 5.41%. In a way, this was seen as a relief as it could have been worse. BP isn't the only oil major to announce a cut, Royal Dutch Shell (RDS.A) (RDS.B) cut their dividend back in April. That was the first time since World War II. Surely, a sign of the changing times.
Now that the dividend cut is priced in, investors can breathe a bit easier. Additionally, BP is aiming to go green aggressively. This is coming with the unfortunate event of cutting 15% of their workforce. This had to do with both going green and COVID-19. In today's ESG investing, this is a great thing. We recently covered the topic of ESG in the energy space recently as well.
HIE hasn't been a fund on the winning side for a while. As the fund tends to stick with a "value" investment style, it has left them heavy in energy. This is also a focus of the fund as a "high-income equity fund." Some of the best places historically to achieve yields in equities, was on the backs of oil companies. This seems to be shifting as energy has been hammered year on year, attributed to the bottom of the performance stack regularly since 2014. With the upper portfolio shifting to financials, tech and utilities - this could see better returns going forward. Although, they list both energy and MLPs separately that does mean putting them together that the largest allocation is still in energy, but has still come down quite significantly from the 40%+ allocations last year.
The other major factor that can contribute to HIE's performance going forward, is its term structure. The fund is set to liquidate in 2024. Should this take place, investors will be given NAV per share back at that time. There is the risk that they can extend out the term, or they could even try to convert it to a perpetual fund. Those are risks investors need to be made aware of. The bottom line, there could be great profits to be made in this fund, but it is a bit more of an aggressive play.
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This article was written by
I provide my work regularly to CEF/ETF Income Laboratory with articles that have an exclusivity period, this is noted in such articles. CEF/ETF Income Laboratory is a Marketplace Service provided by Stanford Chemist, right here on Seeking Alpha.
Disclosure: I am/we are long HIE. 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: This article was originally published to members of the CEF/ETF Income Laboratory on August 6th, 2020.