Beyond The Velvet Rope: 3 Enhanced Income Investments

Includes: BME, GNT, IHD
by: Stanley Barton

I have waited at the theater behind a velvet rope hanging between brass stands, blocking my entrance. There have been times when the usher would unhook one end, letting the crimson rope drop, and I would pass through without breaking stride. Then he would hurriedly hook the rope back before the common folk could force their way past. I have been on both sides of the velvet rope, and, although I am not one of the elitists, I prefer their side of the rope both for the theater and for investing.

The purpose of this article is to provide readers some publicly traded funds so they can practically take advantage of a strategy that has been helping the rich get richer for a long time.

Writing call options on stocks owned in a portfolio is not new, but few individuals actually employ that strategy. For small portfolios, the broker fees might reduce the attraction, and the prospect of limiting how high a stock can go is a deterrent. For example, if I only own one gold miner in my portfolio, I don't want to lose it to a called option contract when some world event causes the price to spike.

There are closed-end funds, or CEFs, that actually invest in categories of stocks and write options on those to "enhance" the income. Many of these pay in excess of a 10% annual yield, partly due to the option premium income. The downside to these is that their stock picks often do not perform as well as other peer mutual funds, as the upside is limited due to the call option contracts.

We think these closed-end, enhanced-income funds are particularly attractive for industry segments that may be currently out of favor, but have strong macro factors that will keep them relevant for years to come. The high distribution makes holding them more bearable as we wait for the industry group to catch fire.

The three macro factors that we will address in this article are:

  1. Aging demographics and growing need for Healthcare
  2. Inflation and growing demand for resources and energy
  3. Growth in Global Emerging Markets

Blackrock Health Sciences Trust (BME) is a closed-end fund that invests at least 80% of its total assets in equity securities of companies engaged in the health sciences and related industries and equity derivatives with exposure to the health sciences industry. Companies in the health sciences industry include healthcare providers as well as businesses involved in providing medical, dental, optical, pharmaceutical or biotechnology products, supplies, equipment or services or that provide support services to these companies. The fund currently has written call options on about 1/3 of its holdings.

The aging of the baby-boomer generation is going to create an enormous demand for healthcare medicines, equipment and services. The global demand from growing markets provides a second reason for optimism in these companies. The healthcare sector has not been dormant, but also has not been an exceptional performer. Part of the obstacle to current appreciation is the new healthcare legislation recently passed and currently being debated in courts. The uncertainty of this legislation has kept these stocks from being supported as much as one would expect, given the potential of the macro factor's future growth implications. Although most certainly we can expect these healthcare suppliers to prosper long term, a high-dividend fund would allow us to wait for that explosion.

BME has a current distribution of a 5.6% annual yield. However, at the end of the past two years the fund declared a special dividend, which increased the return to more than 9%. The distribution came from income and short- and long-term gains. Some investors are wary of distributions of "return of capital," and BME is not relying on that strategy to support its distribution. We will comment on that strategy later, as it is not necessarily as bad as many perceive.

Although we normally prefer CEFs that are selling at a deep discount to the NAV, this fund is selling even to NAV. However, it has performed well and a reliable yield is comforting while we wait for the fund's underlying holdings to take off.

GAMCO Natural Resources, Gold & Income Trust (GNT) invests at least 80% of its assets in securities of companies principally engaged in the natural resources and gold industries. About 50% of the holdings are precious metal related stocks, and about 40% are energy, chemical and agriculture companies. GNT writes covered call options on about 70% of its holding to generate additional income.

Despite the rise in the price of gold in the past two years, many of the gold mining stocks are still selling near the price back then. In my article, "What is Wrong With Gold Stocks: My 3 Theories," I offer some ideas why these stocks have not performed as expected. We think that the increase in the selling price of their product will eventually be reflected in the price of the gold miners stocks. Over the long term, we also think the price of gold is more likely to rise above $2000 than drop to sub-$1000 levels.

In that article, I also mention a sister closed-end fund to GNT, which is GGN. GGN is nearly identical to GNT but since that article, its price has increased beyond the NAV, whereas the NAV of GNT is at the unit price.

The consumption of energy to fuel emerging markets and revitalized mature industries will insure demand for the energy stocks and services. Although many of these have had good increases in share price during the bull run, future growth will likely take these higher over the long term. The prospect for inflation due to flooding the markets with paper money is another argument to hold some resource stocks in our portfolio. Receiving a good distribution from GNT helps us mitigate the conundrum of timing the purchases in a volatile market.

GNT pays a monthly distribution that is currently equal to about 10.5% annually. The GAMCO website indicates that the first three monthly payments of 2012 were distributions from "investment income." However, GAMCO also advises that the 2012 distributions will likely be mostly "return of capital."

ING Emerging Market High Dividend Equity Fund (IHD) is a closed-end fund that invests in emerging market stocks and writes options on 15 to 50% of those holdings. It currently pays a distribution that is equal to 10% annually. It also sells at a slight discount to the net asset value of its holdings. About 60% of the IHD holdings are from China, Brazil, Taiwan, and South Korea. Indonesia, Russia, South Africa, and India, are also well-represented, so this fund gives the average investor an opportunity for global emerging market exposure.

The Emerging Market sector group was flying high a couple years ago, but now that the U.S. market is bulling higher, it has not performed as well. No doubt these markets have growth in their future, so a mutual fund of emerging market stocks would likely be a good long-term investment. The short-term timing may not be perfect, so a good dividend yield will allow a patient investor to have exposure to these markets.

The fund came into existence in April 2011, which was precisely the peak of the MSCI Emerging Market Index. It promptly lost about 25% in the value of its holdings and more than 30% in its unit price. It has now rebounded to about a 13% loss in NAV since inception. The bottom line is that the IHD has a short history and not a very good one at that. However, the unit price has kept pace with the equity market rise in 2012. New closed-end funds are like new cars: the original buyer pays a premium over NAV and the second-hand buyer often gets a discount,

It pays to be a contrarian in considering this fund. The lion's share of the big distribution is "return of capital," which means that the fund did not make enough in dividends and profitable sales of holdings to support the distribution. Although in covered call funds, the return of capital is not necessarily due to bad performance, since rising asset value will counter the premiums collected on the covered calls. The NAV may have appreciated, but if the fund prefers not to sell the assets, the gain is not realized and the distribution is from "return of capital." The fact that the current distributions were mostly return of capital does not mean that at some point in the future the distributions cannot revert to all income and capital gains as in BME above. Of course, as with any investment, a constantly unsupportable dividend may result in a cut in the distribution.

The enhanced income closed-end funds are not for everyone, but they do give investors an opportunity to take a position in market sectors that will be beneficiaries of strong macro factors, while receiving an income stream. As trading tools, the ones that are deeply discounted to net asset value can enjoy a bungee effect once the underlying securities take off. The three listed here are not deeply discounted and are intended as candidates for long-term portfolios. They also offer the opportunity to profit from the covered call premiums that are key to success for many pro investors.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.