ERH: Buy This Vaunted Utilities Fund, An Alternative To DNP

Summary

• ERH is a closed-end fund with a 70/30 utilities and high yield bonds bucketing.
• The fund has enviable long-term returns (the 10-year annualized return clocks in at 11.2%) and risk/reward analytics that compare favorably with the more popular DNP fund.
• NextEra Energy is the largest fund holding, accounting for over 11% of the portfolio.
• This article covers CEFs from our suite of products - we focus on macro portfolio allocation, CEFs, and yield-generating options strategies, targeting overall yearly portfolio returns of 9%+.

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Thesis

The Wells Fargo Advantage Utilities & High Income Fund (NYSE:ERH) is a closed end fund that seeks a high level of current income and moderate capital growth. The vehicle currently sports a 7.6% dividend yield and has experienced a -18% drawdown year to date. The fund is a hybrid one with a split allocation:

The Fund allocates its assets between two separate investment strategies, or sleeves. Under normal market conditions, the fund allocates approximately 70% of its total assets to a sleeve that places a focus on common, preferred and convertible preferred stocks of utility companies and approximately30% of its total assets to a sleeve of U.S. dollar denominated below investment grade (high yield) debt

The fund has very robust annualized 5- and 10-year total returns that sit at 5.4% and 11.2% respectively. From a risk/reward standpoint ERH also compares very favorably to the much better-known fund DNP:

Analytics (Author)

ERH has a similar Sharpe ratio and a lower standard deviation when compared to DNP. What it lacks is the wide adoption and retail following that has seen DNP always trade at a premium to NAV in the past decade. We can see that the fund's maximum drawdown profile is also very similar to DNP's when looking at a 10-year lookback period. DNP does exhibit a higher Sortino ratio (a ratio that illustrates a fund's ability to capture the upside in the market - the higher the Sortino ratio, the better). Unlike DNP or PDT, the Wells Fargo Advantage Utilities & High Income Fund is currently trading at a -4.5% discount to NAV. The vehicle has alternated between discounts and premiums to NAV in the past decade, unlike the constant premium to NAV commanded by DNP.

ERH pays monthly distributions and has a managed distribution plan, at an annual minimum fixed rate of 7% based on the fund’s average monthly NAV per share over the prior 12 months.

We like ERH's metrics and its long-term annualized returns. We feel 2022 is an ideal entry point after the drawdown the fund has experienced this year and the potential mild recession that is upcoming will not be credit driven (hence the HY bucket the fund holds is simply experienced credit spreads widening). We are therefore rating ERH as a Buy.

Analytical comparison to other Utilities CEFs

As detailed above the fund compares favorably to other utilities CEFs:

CEF Analytics (Author)

We can see that ERH has the second highest Sharpe ratio in the cohort and the lowest standard deviation from the subject population. It also exposes the second highest Sortino ratio and the second-best drawdown profile. The fund is surprisingly trading at a discount to net asset value and had a deeply negative z-statistic.

From a total return perspective, we can see that annualized returns are very robust on a long-term basis:

Total Returns (Author)

We can see from the above table that the fund has the 2nd best 5-year annualized total returns and ranks first on a 10-year time horizon.

Holdings

The fund currently has an approximate 68% allocation to Utilities with the rest dedicated to high yield:

Sector Allocation (Fund Fact Sheet)

The top holdings for the fund are with the Equities - Utilities bucket:

Top Holdings (Holdings)

NextEra Energy (NEE) is the largest fund holding, accounting for over 11% of the portfolio. The company is a North American utilities behemoth:

NextEra Energy, Inc. (NYSE: NEE) is a leading clean energy company headquartered in Juno Beach, Florida. NextEra Energy owns Florida Power & Light Company, which is the largest vertically integrated rate-regulated electric utility in the United States as measured by retail electricity produced and sold, and serves more than 5.7 million customer accounts, supporting more than 11 million residents across Florida with clean, reliable and affordable electricity. NextEra Energy also owns a competitive clean energy business, NextEra Energy Resources, LLC, which, together with its affiliated entities, is the world's largest generator of renewable energy from the wind and sun and a world leader in battery storage.

Source: NextEra Investor Relations

On the high yield side, the fund tends to allocate capital to the better rated credits:

Credit Ratings (Fund Fact Sheet)

We can see that half of the credits sit in the double-BB bucket with another 40% in single-B credits. The "CCC" and "Not Rated" buckets are very small as a proportion of the overall fixed income slice. We do not see any default risk in this portfolio. It is built as a more conservative HY allocation and the only drivers for the negative price action this year have been wider credit spreads.

When compared to DNP we can observe an overlap for a number of the top holdings on the Utilities sleeve:

Top Holdings ERH & DNP (Holdings Overlap)

ERH has a top issuer concentration in NextEra, but the other credits in the portfolio have more granular weightings. As per the above table DNP has a 2.7% maximum top issuer concentration.

Premium / Discount to NAV

The fund has alternated between discounts and premiums to NAV:

Premium/Discount to NAV (Morningstar)

Unlike other CEFs that saw an unilateral move to a premium to NAV when the Fed set rates at zero post Covid, ERH has traded at premiums to net asset value prior to the pandemic. Before the recent market sell-off the vehicle was trading at a premium to NAV this year as well.

Well publicized, large capitalization funds such as DNP, with a significant retail following, tend to always trade at a premium to NAV. We feel ERH's performance is similar to DNP's, but its adoption is not as wide.

Distributions

The fund follows a managed distribution plan, which is set at an annual minimum fixed rate of 7% based on the fund’s average monthly NAV per share over the prior 12 months.

Conclusion

ERH is a closed end fund with a hybrid allocation. The vehicle has a 70/30 utilities / high yield bucketing with NextEra Energy being the largest fund holding, accounting for over 11% of the portfolio. The fund has very robust long term total returns which come in at 5.4% and 11.2% for 5- and 10-year lookback periods. With attractive risk/reward metrics ERH compares favorably to its much better-known peer DNP (albeit DNP is an exclusively utilities fund). We like ERH's metrics, and we feel the 2022 drawdown represents an attractive entry point corroborated to the discount to NAV that ERH is currently exhibiting. We are therefore rating ERH as a Buy.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.