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How To Quickly Evaluate A CEF

Dec. 17, 2020 6:07 AM ET10 Comments
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  • Welcome to another weekend blog post from Systematic Income.
  • We take a look at how individual investors or advisers can quickly evaluate a CEF.
  • Take a 2-week free trial of Systematic Income to explore our Income Portfolios and CEF Tool.
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Welcome to another blog post from Systematic Income.

In this post we present how individual investors and advisers can quickly evaluate an individual CEF.

Investors who spend any time on SA will no doubt come across numerous articles discussing individual CEFs or suggestions for alternatives in the comments section. 

There are three main problems with recommendations on SA. First, they tend to mostly skew in the positive direction, ignoring potential negative aspects of any given fund. Secondly, they typically don't provide much context about the rest of the sector. This is akin to walking into a car showroom to buy a car and being shown only one option. And thirdly, certain types of analysis is not straightforward to carry out so often a lot goes missing in any given article or comment. And just because it's not discussed doesn't mean it's not important.

On a recent article of ours someone left a comment that they are invested in HPF so might as well use this CEF as an example. All the screenshots are taken from our CEF Tool.

The first thing we do is eyeball the fund's long-term performance. There are a few different metrics we like to check.

First, HPF 5Y NAV Return is below the fund's average so over the longer-term the fund has underperformed. Secondly, its Alpha which we define as the risk-adjusted pair-wise performance average (basically, a risk-adjusted head-to-head of a given fund against all other sector funds) is very negative. This suggests the fund has delivered middling performance at a higher volatility. Thirdly, the fund has displayed what we call poor COVID resilience - its performance over the 6 months before and after the March drawdown - a period when equities and credit did a roundtrip to the same level. And the fund outperforms a simple preferred ETF (PFF in this case) by under 1% per annum - well below the sector average. 

Secondly, we like to check out its discount valuation. The most useful metrics are the fund's actual discount, its discount percentile and DSSP.

HPF has a 4% discount - quite a bit below a sector average 4% premium so that's not a bad start. The discount percentile is just 11% - pretty good. The DSSP or the discount sector spread percentile is very attractive at just 1%. This tells us the fund's discount relative to its historic relationship to the sector is quite wide.

We then eyeball some key distribution metrics such as current yield and distribution coverage.

Attractive current yield - above the sector average. Distribution coverage looks a bit below 100%, however, creating some risk of a cut down the road.

We also check on the fund's risk profile.

HPF has a 22% NAV volatility - much higher than the sector average. Its NAV drawdown this year was 50% versus 41% for the sector average. Volume is on the low side which could exacerbate big moves. So, overall quite a volatile option in the sector.

So overall, it's not a slam dunk in our view - the valuation is ok but that seems to be for a very good reason.

There are a few more moving parts but those are good enough for a quick spot evaluation that gives us a good idea of whether we should do a bit more research or set the fund aside. 

Check out these and more features of our CEF Tool.

Thanks for reading!

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

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