3 Problems With RQI And Other CEFs

Summary

• Because they offer such a high yield, closed end funds can appear attractive, especially to passive investors.
• Among REIT CEFs, RQI is widely regarded as one of the very best.
• However, RQI and CEFs, in general, suffer from 3 big problems, and for this reason, we avoid most of them.
• Looking for a portfolio of ideas like this one? Members of High Yield Investor get exclusive access to our model portfolio. Learn More »

Photo by Aquir/iStock via Getty Images

When it comes to REITs, there are a few different ways people choose to go about getting exposure to this space. The three most popular choices are ETFs (exchange-traded funds), CEFs (closed-end funds), or choosing to purchase REIT companies individually.

These days, CEFs are becoming more and more common. They do offer several advantages, such as:

• Being actively managed
• Paying often superior yield
• Offering diversification

These benefits attract lots of investors.

However, at the end of the day, CEFs tend to lag behind in performance when compared to other benchmarks. Even Cohen&Steers Quality Income Realty Fund (RQI), which is supposedly the cream of the crop as far as REIT CEFs go.

If we take a closer look, we can see that RQI is taking much higher risks than many passive REIT alternatives, and still offering lower returns:

Source

We can see above that the REIT equity index returned 9.59% compared to RQI, which returned just 9.26%. This lag in performance is not large, but it is very disappointing when you consider that RQI is taking much greater risks via leverage and active investing.

Similar results are seen across the entire CEF space and RQI is not an exception. Below we present the 3 biggest problems with CEFs, using RQI as the example.

1. Excessive Fees

We mentioned above that CEFs can seem attractive because they are actively managed. But this management comes at a cost: high fees and expense ratios.

Compared to Vanguard's Real Estate ETF (VNQ), which has an expense ratio of just 0.12%, you are paying about 15x more with RQI (1.63%). And even though you’re paying for supposedly active management, the top holdings end up looking about the same to those in many of the REIT ETFs you can find on the market.

Perhaps 1.63% still sounds like a small number to you. But the longer your time horizon is, the more this eats into your profits. Over a 20 year investing period, this fee will diminish up to 30% of your gains. If you really want a passive strategy with diversification, you’d be better off opting for an ETF which has many of the same holdings but way less fees.

2. Leverage Problems

Another attractive feature of CEFs is their higher dividend yields.

But how are they able to pay out such a high number? Oftentimes, it is only possible due to the fund taking on excessive leverage.

RQI is a good example of this, as it has a 27% leverage ratio. This doesn’t sound like a problem - until we hit a bear market. During the great financial crisis, RQI declined over 90% because of this additional leverage:

Data by YCharts

During the covid-19 sell-off, a similar thing happened, with RQI dumping nearly 57%:

Data by YCharts

The lesson here is clear: this excessive leverage leads to steep declines and unnecessary volatility. For any additional upside you may achieve in bull runs, the fund will likely lose all of the gains in a bear market.

Many investors have a hard time stomaching volatility like this. In fact, many choose diversified vehicles like CEFs and ETFs hoping to avoid sharp swings like this in the first place. Most people would be better off with an ETF which is unleveraged and thus a lot more stable.

3. Not-So-Active Management

Many try to justify the excess fees of CEFs by saying that you’re paying for the benefits of an actively managed account. However, the truth is that most of the closed end funds are closet indexed. This means that the actual portfolio is almost identical to benchmark sector performance - or, in other words, what you’d likely achieve just by holding an ETF.

Simply juxtapose RQI’s largest holdings to Vanguard’s Real Estate ETF (VNQ), and you can see that 7 of the top 10 holdings are the same:

1. American Tower (AMT)
2. Crown Castle (CCI)
3. Prologis (PLD)
4. Equinix (EQIX)
5. Public Storage (PSA)
6. Simon Property Group (SPG)
7. Welltower (WELL)

In other words, more than half of the top holdings of this actively managed fund are identical as what you’d get by holding a passive ETF with way less fees.

This overlap becomes even more clear if we overlay the performance of the two funds. You can see that RQI tracks VNQ almost identically. In fact, the only difference is the higher volatility you get as a result of RQI’s excess leverage:

Data by YCharts

Conclusion

Due to the reasons above, VNQ and other REIT ETFs are a better choice for almost all passive investors. Even though it carries less risk, you'll likely outperform CEFs in the long run. The holdings are largely the same, but you get to skip out on the unnecessary fees and leverage.

For active investors, you must have enough conviction to choose your own individual stocks. It is possible to construct a portfolio of individual stocks that outperform the benchmark, but in order to do so, you need to know what sets the great stocks apart from the lackluster ones. In our own High Yield Investor portfolio for example, we only choose to invest in <10% of the available opportunities in our target universe.

We look purely for the best of the best, and skip any red flags, such as:

• Lackluster balance sheets
• Poor management
• Significant conflicts of interest
• Excessive leverage

This strict selection process has historically led to superior results:

That said, actively choosing your own stocks also comes with its own sacrifices. You must take the time to research and do your own due diligence to find the companies that will outperform. For investors that don’t have the time or interest to do this kind of work, it’s often a better choice to go the passive route. But if you do, hopefully now you know that it’s often a better choice to stick to ETFs, as you’ll be avoiding the 3 big problems inherent in CEFs.

Analyst’s Disclosure: I am/we are long CCI; SPG. 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.

Comments

[livelaughlikelove]

The reason I chose RQI during 2020 is its steady, monthly income. It gets dividend reinvested. Price appreciation is fine, but not the major goal for my portfolio. Vanguard products are popular; don't you think that if there was too much demand for VNQ that the fees would increase? Meanwhile, Cohen & Steers might see that and possibly decrease its fees for awhile. I've been an investor long enough to understand that anything is possible. I enjoyed High Yield Investor's article and the subsequent posts.

[Jubal04]

I have to admit that I pulled up my purchase records for RQI and RFI. I've owned RFI since 08/14 and RQI since 05/16. Average purchase prices are near identical. share price improvement very similar, but RFI is better. (Plus, I purchased additional shares of RQI in late March, 2020 at around $8.12) It really doesn't appear that the leverage RQI utilizes is of much, if any, benefit.

Thanks for giving me the opportunity to stir around a few brain cells.

[jazznut]

VNQ plunged about 45% during the COVID sell-off last March-- maybe not RQI's 57%, but bad enough. I'll stick with RQI for the higher dividend, but RFI's a good choice if you want to avoid leverage, although it's at a 7% premium currently.

[sjfaris]

I did a comparison and it looks like leverage helps in the short run but does not enhance gains very much in the long run. However, leverage does not cause huge problems.
1YR 3YR 5YR 10YR life
SPY 61.65 18.05 16.32 13.88 9.99
RQI 88.75 14.79 10.65 11.71 7.14
VNQ 48.5 12.18 6.54 9.09 6.67
IYR 47.01 11.26 7.29 8.5 5.73

[High Yield Investor]

@sjfaris Thank you for sharing. That's correct. The active management does not create alpha here.

[OutOfOffice]

Thanks for the thought provoking article for us to be mindful of individual investment objectives. Personally, I prefer non leveraged RFI and individual REITs for taxable accounts. The RQI bought during downturn last year in my IRA was bought with intention for active future rotation.

[High Yield Investor]

@OutOfOffice Thank you for sharing your thoughts. I agree that RFI is a better vehicle.

[Byrnzie]

I bought my position in RQI during last years Covid selloff. I was able to buy at $9.00 a share. Last price quoted was $14.08. So, I have over a 50% gain with a 10.6% yield on my original purchase price. No need to do anything but collect the dividend. I will never sell unless it goes way over NAV.

[High Yield Investor]

@Byrnzie Thanks for sharing. Note that the broader REIT sector is also up by 70% over this time frame. RQI is leveraged so it is expected to have risen even more.

Bought a large discount to NAV, CEFs can make attractive short-term investment vehicles, but I wouldn't hold for the long run.

[Byrnzie]

@High Yield Investor You may be at a different point in your life than I am. My goal with my portfolio is to harvest dividends and never touch principal. Of course you gotta have some things that are growthy such as BST or BMEZ,
STOR, and SCHD. Since I am partially retired, I have a lot of time to turn over investment rocks and study them.

[High Yield Investor]

@Byrnzie I personally wouldn't touch RQI if I was retired. It is much riskier than your average REIT due to the leverage. It almost went to 0 during the great financial crisis. When you are leveraged, you are one black swan away from deep troubles.

[Left Banker]

Let's see, so much wrong here I don't know where to start. How about that first table? RQI stomps on the index every period you cite for ten years. Oops, doesn't fit the bias you've come to this with. Well, one can always find a time period in which A outperforms B when A and B are fishing in the same pond. So you go back almost twenty years? And what do we find? Oh look here, RQI trails by an average of... wait for it... About a basis point and a half a year. And this is your opening argument? Seriously? You're making a case built on a basis point and a half a year against an index since a fund's 2002 inception?

Fact is, a CEF nearly always loses out of the gate. Has to do with how the fund is sold to the early investors. No one who knows anything about the category invests in a new fund until that drag is past. And early loses in any investment are a drag you carry for a long time. If you invested in RQI a few months after its inception its 509% total return to date would have been 556%, quite a bit more than a basis point and a half a year more than the index.

Yes, RQI got hit harder than IYR on the COVID drawdown, but pulling out a few weeks and trying to build a case is silly when RQI over the last year that includes those few week clocked a total return nearly twice IYR's and even knocked the socks off SPY, had a banner year, in the process. ycharts.com/...¬e=&partner=seeking_alpha_635"eLegend&recessions=false&scaleType=linear&securities=id:SPY,include:true,,id:IYR,include:true,,id:RQI,include:true&securityGroup=&securitylistName=&securitylistSecurityId=&source=false&splitType=single&startDate=&title=&units=false&useEstimates=false&zoom=1 What you're doing by pulling out those few weeks is the worst sort of cherry picking to build your case.

Yes, RQI has 7 of its top ten positions in common with IYR, but it still managed to beat the ETF this last 12 months, 24 months, 36 months, 48 months, shall I go on? There are probably several six or eight week periods in there that you can pick out where RQI lagged just like you found a period where RQI lagged the index.

You don't like leverage? Fine, that's a legitimate preference. But bear in mind than RFI, with a very similar portfolio to RQI's but unleveraged, has similarly beaten the index and the ETF. Click that link above and add RFI to the chart and see for yourself. But you don't even mention it. Of course not. After all, it doesn't fit the biases you've cherry picked data to support.

Fact is Cohen and Steers is an excellent manager of real estate investing. The management fees you object to so strongly are a bargain considering that one gets top of the class management of real estate exposure in a portfolio without ever having to think about it. Maybe a devoted REIT investor who thinks about nothing else can do better, but most RQI investors are looking for REIT exposure without having to devote that kind of commitment to it.

[High Yield Investor]

@Left Banker lol the table comes literally from their own website: www.cohenandsteers.com/...

They show it themselves that they have failed to create alpha and underperformed since inception, despite taking much greater risks. These are not my calculations.

You are so in love with your vehicle that you cannot accept any counter-view points and try to discredit any opposing arguments by calling them "wrong". I think it is rather childish.

[Think. Focus. Health. Wealth]

@Left Banker - you must also consider the source...Jussi Askola & Team
seekingalpha.com/...

www.leonbergcapital.com/...

>Leonberg Capital is a contrarian, value-oriented investment boutique specializing in alternative asset classes with high yield potential. We focus mainly on REITs, mREITs, MLPs, BDCs, CEFs, Yield Cos, Preferred shares, and other high yielding equity sectors that are often mispriced and present opportunities for active investors. <

I notice in above paragraph from Leonberg website they focus on CEFs, yet in this current article they state:
"That said, actively choosing your own stocks also comes with its own sacrifices. You must take the time to research and do your own due diligence to find the companies that will outperform. For investors that don’t have the time or interest to do this kind of work, it’s often a better choice to go the passive route. But if you do, hopefully now you know that >>> it’s often a better choice to stick to ETFs, as you’ll be avoiding the 3 big problems inherent in CEFs.<<<

Quite confusing??? They focus mainly on CEFs, yet promote ETFs due to the problems inherent in CEFs.????

​

[High Yield Investor]

@learning to be patient with mr mkt We don't fall in love with any of our investments. CEFs can be attractive as trading vehicles when avaialble at steep discounts to NAV. Some exceptions can also be attractive long-term holds. But generally speaking, we dislike most CEFs, including RQI. Most often ETFs will do better than CEFs.

[MAYHAWK]

Again with that old "excessive fees" argument. I would rather have a CEF with 2% in fees (taken before the distribution I might add) and a 5-7% yield than to have ETF with .2% fees and a 2% yield. Fees only matter if they come out of your distribution such as "advisers" charge. Anything taken before the distribution means nothing to your yield unless you want to play the "but it would pay more with lower fees" game.

[High Yield Investor]

@MAYHAWK You don't seem to quite understand how this work. The management fee comes out of your capital. It is a % of your assets that's paid each year. The dividend is only high because of the leverage. You are paying a high fee for active management that has failed to produce alpha since inception.

[MAYHAWK]

@High Yield Investor,

I understand perfectly well how it works. It would appear that you fail to understand. The fee is coming out of earnings before I receive my distribution, the same as executives and workers receiving their pay before my dividends in a business. Are there CEF's which use destructive ROC to maintain the high yield, of course. It is on the incumbent upon the individual investor to do their research before investing in a particular fund. There are plenty of good CEF's with little or no ROC or with non-destructive ROC. If you would rather receive a paltry 2% because the "fees" are only .5% rather than receiving 7% because the "fees" are 2% that is on you. I prefer to make the greater yield. You are doing everyone a disservice with your constant "fees bad" litany. Throwing around buzz words like "alpha" doesn't make you any more correct. Not all high yield CEF's rely on leverage and you talk about leverage as if it is a bad thing. Leverage used properly is quite useful.

[Left Banker]

@High Yield Investor

the lack of understanding here is no with @mayhawk.

You can tell precisely what the leverage adds to the yield: 40bps. How? Compare to unleveraged RFI at 6.41%.

Do us all a favor and stick to what you know. Saying RQI has not produced alpha is just absurd.

www.portfoliovisualizer.com/...

the only thing you can say is leverage increases volatility. Hardly a news flash item. But that volatility can also be a strategic asset for well timed investments. Or, forego the leverage and buy and hold the unleveraged counterpart.

[draconian5849]

An expense ratio of 1.63% is pretty outrageous.

Combine that with the 90% drawdown of RQI during the Great Recession and those things should give investors pause.

[High Yield Investor]

@draconian5849 I agree with your thoughts, especially since they have not produced any alpha since inception. The praise is not deserved.

[Monthly Income Investor]

@High Yield Investor How much alpha has it created since the crash of 09?

[U2DNA]

Easy to estimate (omitted) metrics.
1. a back of the envelope estimate of "short-term NAV beta" relative to VNQ
(loss amplification due to leverage)
4 Mar - 23 Mar ratio: dividend-adjusted returns of XRQIX vs VNQ =
0.6083/0.5318 2020 = 1.14 loss amplification on the way down.
2. XRQIX:VNQ daily return correlation coefficient = 0.99 (or R-squared = 0.98)
4 Mar - 20 Nov 2020
per www.portfoliovisualizer.com/...
3. Unanswered Question:
Exactly how much overlap is there between the VNQ and RQI portfolios?
% Active share is the usual calculation. However, I prefer the less pejorative term "portfolio overlap", which is defined as "100% - Active Share%". It turns out that the daily return correlation coefficient (2 above) is usually > 0.98 when portfolio overlap% is above 50% to 75%. (I haven't checked the numbers.)
I invite the author to verify the above statement by actually doing the Portfolio Overlap calculation from the latest quarterly report.

Yes, RQI has a very high expense ratio. Do CEF investors care?
Yes, RQI has expensive leverage which increases beta relative to VNQ.
Yes, it looks like RQI may be a closet indexer. Is it?

It would be nice to know if RQI is providing ANY value-added active portfolio management expertise. If there was ever a time when active REIT portfolio management skill might result in superior investment returns, it would be during the period 2020-2022. I am still waiting for RQI to show some evidence of superior portfolio management skill.
The question is can RQI beat either VNQ or "monkeys with a dartboard".on a leverage/expense/risk adjusted basis?

[High Yield Investor]

@U2DNA "It would be nice to know if RQI is providing ANY value-added active portfolio management expertise."

Given that they have underperfromed their benchmark since inception, despite taking greater risks, you have your answer there.

[fhbecker]

Like all stocks, its best to buy CEFs during market panics. Most (all?) CEFs will trade at huge, double digit NAV discounts to their underlying holdings. Just limit your purchases to those times and enjoy your CEF holdings and their high payouts. When they trade at a premium to NAV, usually best to get out.

[jasonjones]

@fhbecker. I should sell BME, BUI, and BST then?

[High Yield Investor]

@fhbecker Yes, if available at a large discount, then it is a different story. Feel free to join us for a 2-week free trial to access all our Top Picks: seekingalpha.com/...

Have a great day!

[jasonjones]

@High Yield Investor So you can do better than CEFs with your stock picking service?

[ScottHB]

Is it price or total return that's shown in the first graph comparing VNQ to RQI? If it's price rather than total return then your case is seriously diminished.

Some may find RQI's extra volatility to be worth it there's extra income being realized along the way due to yield differentials. This is especially true if dividends are being reinvested so that the extra income is compounding. And greater price volatility can be very beneficial to dollar cost averaging when reinvesting dividends because of the greater number of shares that are purchased during the deeper price dips.

Even if I agreed that volatility isn't a deeply flawed metric for risk (which is a whole separate topic) I can't accept that the thesis as presented is correct because you haven't clearly laid out the information to support it.

[jasonjones]

@ScottHB They deleted my comment which was similar to this one. The author generalized that all CEFs are not good investments, however his reasoning is flawed.

[High Yield Investor]

@ScottHB RQI uses a lot of leverage, which is added on REITs, which are already leveraged. That's real risk, not just volatility. RQI nearly went to 0 during the great financial crisis. Not a vehicle for a retiree.

[macebe]

@ScottHB the author posted a link below the first table, which takes you to the Cohen & Steers website, which shows the figures in the first table are total returns, not price returns.

[Michaelsbender]

Are you including the dividends in your return numbers showing price and NAV?

[High Yield Investor]

@Michaelsbender Yes

[High Yield Investor]

@High Yield Investor It is directly from their website. It is total return.

[jeterno]

You mention the high CEF fees, but don't point out that for CEFs, fees include non-management expenses, particularly interest on the leverage they use. It's not all going into the managers pockets.

[High Yield Investor]

@jeterno Yes it is. The fee including the other expenses is even larger as a percentage of assets.

[Dennis O]

I went into seeking alpha plugged in RQI went to the Momentum column then compared it to VNQ in the TOTAL return column and you can pick 6mo.-1 yr.- 5yr.-10yr.- max.- and RQI wipes the plate with VNQ. The only time VNQ beats is during the 10 yr. where just market price is looked at . I will take my chances with RQI and drip the Dividends which are near 7%. And to my understanding that Dividend rate also figures in the Fees. I personally do not look at fees as much as some as long as my net return is good.LIFE IS GOOD.

[TaiPan]

@Dennis O
I use Dividend Channel to calculate total returns. Even over the past ten years, but also over all other periods I tested, RQI has outperformed VNQ, though with significantly-higher volatility.

I just wonder how RQI investors cope with its volatility. In the 2008 recession, RQI plunged 91% peak to trough, and in March 2020 it declined 60%. It takes a true believer to hold on through such earthquakes.

[High Yield Investor]

@Dennis O You cannot just start your time period at the beginning a major bull run and ignore the previous recession. This is a leveraged vehicle. You need to include the bull and bear markets. Since inception, it has underperformed passive benchmarks. No value added.

[Ed needs bucks]

@TaiPan It makes it easier to hold on when you are getting paid cash to do so. That cash gets reinvested at the lower prices and there you go.

[Ed needs bucks]

Curious why you ignore the 3 things that are actually important to CEF investors? Total Yield, Discount to NAV, Dividend Stability.

5 year total yield RQI = 62% Ten year = 196%
5 year total yield VNQ = 36% Ten Year = 137%

Discount to NAV for RQI at current price is 2.8%

RQI hasn't cut it's distribution since 2010
VNQ has an inconsistent distribution policy at best.

For income investors, such as retirees, RQI is a most excellent investment vehicle.

[High Yield Investor]

@Ed needs bucks You cannot just start your time period at the beginning a bull run and ignore the previous recession. This is a leveraged vehicle. You need to include the bull and bear markets. Since inception, it has underperformed passive benchmarks. No value added.

I don't pretend that VNQ is a perfect vehicle, that it provides much better risk-to-reward over a full cycle.

[High Yield Investor]

@Ed needs bucks RQI nearly went to 0 during the great recession. This is too risky for retirees.

[Ed needs bucks]

@High Yield Investor ...but only cut and didn't eliminate it's dividend. Brought it right back up after a year and hasn't blinked since. Perfect investment for retirees. Who sells a stock that is paying you a dividend in a crash anyways?

[Seatonmanagement]

Fair points

[High Yield Investor]

@Seatonmanagement Thanks for your interest!

[Tim Mc]

I'm mostly a dividend growth investor, however I have added a high yield component that has boosted our monthly income. I own REITs HASI, O, STAG, VER, WPC and CEFs AWP, RFI & RNP in our IRAs. CEF's make up only 8.7% of our retirement portfolio by value, but generate 17.9% of the distributions. Almost all distributions & dividends are reinvested in our IRAs.

By contrast, our taxable portfolio has 16 CEFs that cover most major sectors, including REITS with RFI, RNP, RQI and stock WPC. Some CEFs have had very nice capital appreciation (BST, CGO, CHW and UTF). All of our CEFs are in the black and generating distributions monthly. I'm only dripping on a few CEFs now, such as DNP and UTG as their current yields are above their 5-year average yield.

CEFs are another tool for me to achieve my goals. That stated, I'll likely look into adding VNQ as a more conservative REIT component to both our retirement and taxable accounts, but certainly not as a high yield play.

[High Yield Investor]

@Tim Mc Thank you for sharing your thoughts.

[TriniIndi]

@Tim Mc Hi Tim, Why do you keep the CEFs in your taxable account? Is there some advantage to this in the case of CEFs? I am a newbie to CEF investing.

[Tim Mc]

@TriniIndi Our retirement accounts are mostly dividend growth stocks, although we have CEFs in our IRAs as well.
I primarily use our taxable account to generate income that we can use now. It also serves as an emergency fund, so a percentage of the portfolio is held in money market or more conservative ETFs.
Secondly, our taxable account is a training ground for the eventual conversion of growth from our DG stocks like MSFT, TGT, MCD, PEP, V, etc. into higher yielding CEFs and ETFs for retirement income in the future. As a side note, it's exciting to think of where those stocks will be in 10 years or so. Just converting our MSFT position into CEF FOF today would increase our income 10X from $307/yr. to $3300/yr.
For tax considerations I try to grow qualified distributions which are taxed at a lower rate. For example, UTF and UTG are 27% of our taxable account and both pay out qualified distributions.
I hope this helps explain how I use CEFs in our taxable accounts.
Best regards,

Tim

[sjfaris]

Using Morningstar TR numbers it looks like RQI beats.
1YR 3YR 5YR 10 15
RQI 88.75 14.79 10.65 11.71 7.14

VNQ 48.5 12.18 6.54 9.09 6.67

[High Yield Investor]

@sjfaris Nice way to ignore the great financial crisis, which nearly bankrupted RQI. Even starting from this very low base and being leverage, the difference is so small that it does not justify the much greater risk of the vehicle.

[sjfaris]

@High Yield Investor If one plans for the pandemic or great financial crises one would never invest. For my account I have earned 7.78% av. annual return since 2017. The spy is better at around 16% and VNQ is only 6.54.

[Jubal04]

Curious how you got the 1yr market price return at 4.3%? The share price of the shares i purchased in Mar 2020 are up 76% and that doesn't included distributions.

Also, i don't think their share price drop was 5hat much related to leverage, more related to landlords inability to collect rent.

[High Yield Investor]

@Jubal04 It is directly from their website. Probably updated on a monthly basis. If you start at the bottom of the crash, the results are of course different.