Beware Of Underperforming General Equity CEFs

Aug. 31, 2020 7:55 AM ETVT, AGD, AOD, GLQ, ETG, HEQ, HTY, LGI, RGT, EOD, ETO24 Comments

Summary

  • Equity CEFs are one of the few ways investors can receive strong distributions from equity investments, and with strong discounts to boot.
  • However, many general equity CEFs underperform their benchmark after fees are taken into consideration, and may even deliver negative alpha, especially during downturns.
  • Investors in general equity CEFs need to balance the potential advantages of steady distributions and wide discounts against high fees and potential underperformance versus the benchmarks.
  • This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Get started today »

General equity CEFs are those focusing on U.S., global, and emerging market equities, but without a specific sector focus, and without the use of any hedging or covered call strategy.

CEFs are one of the few ways investors can receive strong distributions from equity investments, and with strong discounts to boot. Unfortunately, with general equity CEFs, the potential advantages of steady distributions and wide discounts need to be balanced against the high fees and potential for underperformance versus the benchmark. In my opinion, the average investor, including retirees with monthly spending needs, could achieve stronger investment results by investing in a low-cost equity index fund but selling shares to meet expenses.

Due to the above, I rarely cover general equity CEFs, and these are not included in the CEF/ETF Income Laboratory model portfolios, which either use a covered call strategy (e.g. EXD, CII), or have a specific sector focus (e.g. HQH, BSTZ).

I'll start with a short qualitative analysis of CEFs and ETFs, as we need to know what differentiate these to understand some of the issues with CEFs, before doing a more quantitative analysis of the former. The article focuses on general equity CEFs, and results and conclusions are likely to be different for CEFs of other asset classes.

Closed-end Funds and Exchange-traded Funds - Comparative Analysis

Exchange-traded funds, or ETFs, are essentially baskets of securities, can be redeemed for said basket of securities, and always at the price of the same. The latter is usually referred to as trading at net asset value, or NAV. Buying the SPDR S&P 500 Trust ETF (SPY) is functionally equivalent to buying its underlying basket of securities, the S&P 500.

Closed-end funds, or CEFs, are essentially investment companies, which invest in baskets of securities. CEFs rarely trade at the exact price of their underlying holdings for the same reasons companies rarely trade at book value, including market, industry, and investor sentiment, management capabilities, past performance, and supply and demand.

The key structural difference is that ETFs generally trade at NAV, meaning at the price of its underlying holdings, while CEFs usually don't. This allows savvy investors to buy CEFs at a discount, with all the benefits that entails.

Besides this, there are CEFs and ETFs with wildly different characteristics and behaviors, a few of which are unique to one structure or the other. Nevertheless, some trends emerge.

Most CEFs are / have:

  • Actively managed, so performance is partly dependent on management capabilities and investment strategy.
  • Proprietary or ad-hoc investment strategies, so evaluating these can be difficult.
  • Leveraged, which amplifies returns, yields, and volatilities.
  • Higher expense ratios, which directly reduces shareholder returns.
  • Managed distribution policies, so distributions are partly funded through capital gains and asset sales, and are not indicative of the fund's underlying generation of income, dividends, and the like.

On the other hand, most ETFs are / have:

  • Passively managed, so performance is mostly dependent on broader economic and industry conditions.
  • Transparent, clear, and open investment strategies, so evaluating these is easy.
  • Unleveraged, so returns, yields, and volatility are comparatively lower.
  • Lower expense ratios, which leads to comparatively greater shareholder returns.
  • Income-only distribution policies (unsure about the actual name of this), so distributions are exclusively funded by the income generated by the fund, net of fees.

There are many exceptions to each of the bullet points above, but they do generally hold true.

Combine the above with the fact that only 23% of active funds outperform their passive counterparties, with even lower averages for equity funds and those with higher-than-average expenses, and it would be difficult for the average actively managed equity fund, whether a CEF or mutual fund, to outperform the benchmark on a total return basis.

General Equity CEF Analysis

Some comments on the information and funds selected. Feel free to skip to the results if these are not of interest.

I selected applicable general equity CEFs from CEFConnect, including U.S. equity, global equity, and emerging market equity.

I've excluded covered call funds due to the difficulties involved in selecting a proper index for the wide variety of these CEFs, and sector equity plus single-country equity due to the small number of funds per sector and country.

I've excluded funds for which there was less than five years of performance information available, as well as a couple of funds whose holdings seemed to differ from those of its subdivision (global funds which only invest in Europe and the like).

I selected all relevant performance information from CEFConnect, and calculated TTM price returns using data from AlphaVantage.

I wanted to use MSCI indexes, but couldn't find adequate index funds for some of the equity subdivisions, same for FTSE indexes. I settled on applicable Vanguard index ETFs, so the Vanguard Total World Stock ETF (VT) for global equities, the Vanguard FTSE Emerging Markets ETF (VWO) for emerging market equity, and the Vanguard Total Stock Market ETF (VTI) for U.S. equity.

I also did a quick analysis of the performance of these funds and indexes using data from CEFdata, and the results were not materially different.

Results are broadly similar for the three equity subdivisions selected. Let's focus on global equities, mostly because I'm a bit more familiar with these funds.

Results

By my calculations, most global equity CEFs consistently underperform their benchmark, especially during downturns. Underperformance averages between 1.5% and 3.0%, much higher during downturns, although performance varies widely. Results are as follows - take special note of the difference in returns between the average CEF and VT, at the bottom of the table:

(Source: CEFConnect - AlphaVantage - chart by author)

As can be seen above, the performance of most global equity CEFs has lagged the benchmark. Only the Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO) and the Lazard Global Total Return & Income Fund (LGI) have outperformed the index, although their performance is somewhat dependent on the time period in question. The Aberdeen Global Dynamic Dividend Fund (AGD) and the Aberdeen Total Dynamic Dividend Fund (AOD) also performed well during the time period in question, although their longer-term performance is much worse:

Chart

Data by YCharts

The underperformance is partly due to the fact that all global equity CEFs have very high management fees and expense ratios.

(Source: CEFConnect - AlphaVantage - chart by author)

As can be seen above, the average global equity CEF is about 1.6% more expensive than its index, with most of the difference being attributed to management fees. These fees are obviously a significant reason for why these funds underperform, and will almost certainly result in significant underperformance moving forward, as extremely few investment managers are able to generate sufficient alpha to overcome these fees.

Global equity CEFs do have a certain advantage over the index for the income investor. These CEFs generally boast distribution rates of between 8% and 11%, much higher than VT's 2.08%. Although these distributions are very enticing, they are mostly return of capital, meaning that the fund is selling assets and shares and distributing the proceeds to shareholders. Let's take a quick look at LGI's latest annual report to see what I mean.

https://static.seekingalpha.com/uploads/2020/7/19/48557980-15951964331423252.png

(Source: LGI Annual Report)

As can be seen above, LGI distributed about $10.5 million to shareholders in 2019, of which $1.8 million came from net investment income, basically dividends from the fund's underlying holdings, with the rest being funded through capital gains or asset sales. From the above, and taking into consideration LGI's current 8.40% distribution yield, it seems that the fund's underlying holdings only generate about 1.44% in income, a bit lower than VT's 2.08%. Figures are almost certainly going to be different for other funds, but most of these should be engaging in significant return of capital distributions.

Return of capital distributions are not wrong per se, but they are definitely not an indication of a fund's underlying generation of income, valuation, or expected shareholder performance - they are simply an indication of the total value of the assets that the fund intends to sell and distribute to shareholders every year. Investors can always decide to sell assets themselves, so these are not really all that material.

To prove the above, I decided to use Portfolio Visualizer to backtest the performance of some of these funds, just to show that these distributions make very little difference. I assumed a starting portfolio balance of $1 million, quarterly withdrawals of $21,250, equivalent to an 8.5% yield, and ran the backtest starting from 2015. This backtest is roughly equivalent to comparing the performance of these funds, assuming that the investor uses the distributions from the CEFs to fund his retirement but is forced to sell shares of VT to do the same.

Results are as follows:

https://static.seekingalpha.com/uploads/2020/7/19/48557980-15952021916583652.png

(Source: Portfolio Visualizer - chart by author)

Compare the performance of the table above with the first table in the article. What you'll find is that CEFs with comparable shareholder returns with VT, basically AGD and AOD, also have comparable performance when taking withdrawals into consideration. Funds with stronger performance, LGI, likewise outperform. Funds with weaker performance, like HTY, continue to underperform.

The distributions themselves are telling us very, very little, although they do seem to have a very small effect. AGD and AOD generally perform about as well as VT, but outperform by about 0.10% when withdrawals are realized. Fiddling with the visualizer shows similar effects for most funds, usually worth 0.10-0.20% in returns. I'm unsure of the reasons behind these small differences - the positive impact from the distributions themselves is definitely a possibility, but there could be issues with discounts and premiums, or with the specific timing of the withdrawals. In any case, it does seem that global equity CEFs are the stronger choice for retirees if their performance at least matches that of their index, but that this is rarely the case.

From the above, I can confidently say that for the total return investor, VT would have been the better, stronger investment choice for investors and retirees, even though the fund's yield is significantly lower than that of its peers.

Results are significantly worse for U.S. equity and emerging market CEFs, for the same reasons. Relevant tables below.

U.S. Equity

(Source: CEFConnect - AlphaVantage - chart by author)

Emerging Markets

Conclusion

As a reminder, the “general equity” CEFs discussed in this article do not include most of the equity funds selected in our CEF/ETF Income Laboratory model portfolios, which have a specific sector focus and/or include a covered call writing strategy.

The average general equity CEF significantly underperforms its benchmark due to excessive management fees and negative alpha, and equity index ETFs are generally better for the total investor. For the income investor, the steady distributions from general equity CEFs may have appeal, but they should be aware that a significant proportion of this is coming from return of capital.

Investors have, in my opinion, two main choices.

First, and assuming that they wish to remain invested in general equity CEFs, they should conduct extensive due diligence on any and all applicable funds, to improve the odds of selecting the best-performing CEFs, which do perform quite well. Buying a heavily discounted CEF from a top-tier manager can result in outsized gains and distributions, although this is easier said than done. Services like the CEF/ETF Income Laboratory are, of course, an attempt at doing this.

Second, they can simply choose to invest in low-cost index or smart beta ETFs, which perform reasonably well. Retirees can just sell assets when needed, for less than CEF investment managers charge. I believe this to be a very good choice, but overlooked by many.

As a final point, my analysis obviously simplifies and ignores some important aspects of investing in these funds, including taxes, the timing of withdrawals, rotations strategies, and the like.

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This article was written by

Juan de la Hoz profile picture
7.38K Followers
CEF/ETF income and arbitrage strategies, 8%+ portfolio yields

Juan has previously worked as a fixed income trader, financial analyst, operations analyst, and economics professor in Canada and Colombia. He has hands-on experience analyzing, trading, and negotiating fixed-income securities, including bonds, money markets, and interbank trade financing, across markets and currencies. He focuses on dividend, bond, and income funds, with a strong focus on ETFs, and enjoys researching strategies for income investors to increase their returns while lowering risk.

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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/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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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