In March 1970, at the tender age of 10, I wrote a theme called “The Sport I Prefer,” in which I tried to explain to my primary school teacher what made football (soccer) my preferred sport. I explained the fundamentals of football and briefly reviewed other sports, from the relay race to the giant slalom. I told her that I like to play football, but warned her that “after playing a lot, a few times I sweat, and other times I get tired.” I told her that I was rooting for Fiorentina, my city’s football team. The team had just won the Italian Championship and was playing in the European Cup of Champions, the predecessor to the current Champion’s League.
I concluded my theme with a wish: “I hope to become a player of my team: Fiorentina.” I illustrated my theme with a drawing with the lily of Florence and the purple flag, the team color for Fiorentina. (It is for this reason we Florentines say we have a “purple heart.”) My grade? 7 (out of 10).
Fortunately, that long ago theme wasn’t lost: I found it after my mother’s death, along with another theme about my memories (you can imagine at 10 years...) and a couple of school report cards, carefully preserved in a trunk in the attic. I’m proud of the ideals expressed in that paper, even though I never became a football player. At the age of fifteen my love for volleyball, which I continued to cultivate until I was fifty, replaced my passion for football.
As with many childhood aspirations (I wanted to be a truck driver, an archaeologist, a biologist), the careers I imagined as a child were replaced by other dreams. After twenty-five years in the publishing world, here I am talking about finance; an activity that started as a hobby and has now become a great passion.
In the title of this article, I risked provocation by combining Warren Buffett’s idea of Focus Investing in stocks with my focus on CEFs. In his book, The Warren Buffett Portfolio (1999 edition, page 2), Robert G. Hagstrom summarizes Buffett’s ideas as follows:
Choose a few stocks that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those stocks, and have the fortitude to hold steady during any short-term gyrations.
For the purpose of my rule of thumb for CEF investing, Hagstrom’s guidance can be restated as: “Choose a few CEFs that are likely to produce above-average returns over the long haul, concentrate the bulk of your investments in those CEFs, and have the fortitude to hold steady during any short-term gyrations.”
But how do you choose CEFs “that are likely to produce above-average returns over the long haul?” The essence of the matter lies in the necessary due diligence and attention in order to not be enchanted by unsustainable yields in the long run. With returns that are often double-digit percentages, CEFs are widely considered an ideal tool for income investors. CEFs are funds that contain dozens of holdings within them, but of course respond to market dynamics just like any single financial security and are subjected to the continuous arm wrestling between short-term speculation and long-term investment. Like any other security, a CEF must be carefully studied and evaluated to understand its advantages and pitfalls. Above all, this study is important in order to avoid exposing yourself to painful losses in your capital account when you select funds with returns that appear too good to be true; indeed, sometimes they are.
Over the years my passion for finance has focused more and more on the study and selection of CEFs. What fascinates me most about CEFs is that they are investing structures characterized primarily by the fact that they are closed. After the Initial Public Offering (IPO), capital does not flow into them when investors buy shares or flow out when investors sell shares. Unlike open-end mutual funds, shares of the securities that comprise a CEF are not individually traded with the sponsoring fund family. Instead, the CEFs themselves are traded in the marketplace at prices that can be above (at “premium” to) or below (at “discount” to) their NAV.
Because CEFs do not have to issue or redeem shares daily, fund managers can count on a relatively stable capital base and can thus devote themselves entirely to portfolio management, without worrying about holding excess cash to meet unexpected redemptions. As I mentioned in my previous article, “A Rule of Thumb for Long-Term CEF Investing,” CEFs have the additional feature of being allowed to resort to the use of leverage as a management strategy. Although this strategy increases the volatility of a CEF, it also increases income and enhances returns.
From the moment I discovered them, I understood that CEFs would represent the ideal investment tool for my needs. As a result, I gradually concentrated my interests and resources on them, with great satisfaction for the past seven years. Over that time I have learned to know and live with their weaknesses, to the point of developing a personal, modest “rule of thumb” for successful long-term investing in CEFs. This rule, which is based on the interactions between the NAV performance, the discount or premium on NAV, and leverage, is simply stated as:
Choose a CEF with a positive NAV since inception, the highest discount, and the lowest leverage. Consider the distribution only after meeting the first three criteria.
One of the primary points in my previous article, which I want to reiterate here, is the importance of NAV performance over time. For me, this is the primary criteria to consider when evaluating a CEF, whether it is an equity fund or a bond fund. For equity funds I want the NAV performance to be largely positive; for bond funds a value around parity is also acceptable, because it should prevent the erosion of NAV due to an unsustainable distribution.
Going once again to Robert G. Hagstrom’s book (work cited, page 79), he states:
If you own a lousy company, you require turnover because, without it, you end up owning, for a long term, the economics of a sub-par business. But if you own a superior company, the last thing you want to do is to sell it.
He further points out (work cited, page 7) that the secret is to choose
…companies with a long history of superior performance and a stable management, and that stability predicts a high probability of performing in the future as they have in the past.
Although Hagstrom is referring to stocks, I believe his argument can be extended to other instruments on the market, including CEFs. In the CEF world, the best performance indicator is the NAV since inception trend, which reflects the value of each fund’s assets. A portfolio that performs well over time is an indicator of reliable and consistent management and thus likely long-term results, which should be the goal of every CEF investor.
Hagstrom’s argument illustrates the reason that my primary focus when evaluating CEFs is on the only data that can reliably attest to the quality of a CEF: the trend of its NAV since inception.
Although it’s always important to keep in mind that (positive) past results are no guarantee for the future, after the explosive rise in share prices following the March 2020 market sell-off, I wonder what value creation can be expected from CEFs still in negative territory after such a powerful rebound. What will eventually happen to those CEFs during a bear market? How far will they go, and above all, will they ever be able to recover further lost ground?
I frequently read articles, both on the net and here on SA, that showcase CEFs with excellent returns or attractive discounts on the NAV. However, when I research the NAV performance of these funds, I find that in some cases they have lost up to 60 or even 70 percent of their value since launch. What is the point, I wonder, of investing in these funds, when there are others that have not only paid their distributions regularly, but have also increased the value of their assets over time?
To illustrate how my rule of thumb operates with some concrete examples, let’s examine a selection of CEFs that pay a monthly distribution and are not currently in my Cupolone Income Portfolio. These CEFs, listed in alphabetic order, show a positive NAV performance since launch of at least 10%, and in some cases even much higher.
The following table shows the NAV performance, Discount/Premium, and Leverage for each of these CEFs, sorted in descending order of their NAV performance. For the purposes of this discussion, the table does not show the distribution rate for each fund. (All data is as of October 14, 2021.)
Note: Similar funds from the same investment houses, such as BMEZ, BSTZ, or NXR are not included in the table even though they have a positive NAV.
All in all, a portfolio composed of the securities in this example would certainly show a lower volatility than my Cupolone Income Portfolio, regardless of the yield. Despite my Cupolone Income Portfolio having a potentially higher volatility, I consider that “a calculated risk,” if it’s true that risk comes from not knowing what you are doing.
My Cupolone Income Portfolio (named for Brunelleschi’s dome in Florence), which is entirely dedicated to CEFs, currently consists of the following 12 titles:
The following table shows how the NAV performance of the CEFs in my portfolio currently fit within my rule of thumb for long-term CEF investing.
As you can see, all the CEFs in my portfolio are leveraged, and the NAV performance varies enormously from one to another.
See my previous article, “A Rule of Thumb for Long-Term CEF Investing,” for a detailed examination of how the funds in my portfolio currently fit within my rule of thumb for long-term CEF investing.
Brains’ll only get you so far and luck always runs out.” (Harvey Keitel in “Thelma & Louise”)
What do I do about funds like DSL and GGM, which have been constantly losing value but have been in my Cupolone portfolio for years? If I built this portfolio today based on my rule of thumb, I probably wouldn’t even take them into consideration. In fact, perhaps now might be a good time to at least liquidate DSL as it is currently ahead of the load price, thereby avoiding any slips at the next market correction.
As for GGM, which is still at a bit of a loss, I decided to wait for its “new life” in GOF, whose merger is expected to be effective with the open of the New York Stock Exchange on October 25, 2021. As announced by Guggenheim Investments, “Upon closing of the Mergers, GOF will continue to be subject to its current investment objectives, policies and restrictions. Shareholders of GPM and GGM will receive newly issued common shares of GOF, the aggregate net asset value (not the market value) of which will equal the aggregate net asset value of their common shares held immediately prior to the Mergers.”
Because I do not like to increase my holdings in the securities already in my portfolio, which would average their load price upward, my next purchases will be aimed at securities that, if not in whole, at least partially meet the characteristics outlined with my rule of thumb for long-term CEF investing.
I am currently following three CEFs, all three of which are invested in sectors not currently present in my “stable” or which use alternative portfolio strategies. Of the three, only CCD has a leverage of around 30%, which I hope is a calculated risk.
For the moment, I have included these CEFs in my watch list, waiting for the right opportunity to buy them; when everything is expensive you must be willing to sit on the sidelines for a while.
This article was written by
Disclosure: I/we have a beneficial long position in the shares of DSL,ETO,EVT,GGM,HTD,PCN,PDI,PDT,PTY,RQI,UTF,UTG either through stock ownership, options, or other derivatives. 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.