Best Closed-End Funds
July 24, 2012
Given the complexity of CEFs, are they worth the bother? There are several potential benefits to the CEF structure. First, the fund’s ability to use leverage allows more latitude in managing the portfolio. Because the fund company itself cannot be forced to redeem shares, CEFs are an excellent vehicle for portfolio of relatively illiquid assets. CEF managers do not have to maintain a balance of cash to meet potential investor redemptions. Nor do they need to be prepared to deploy large inflows of new cash (as open-end fund managers do).
CEFs are more flexible as an income-generating fund structure for these reasons. Indeed, in a survey of investors, Morningstar found that income generation was the primary motivation for choosing CEFs.
Finding the best CEFs
Analyzing CEFs is complicated because of the discount or premium of share price to NAV, the different forms of distribution (such as income or return of capital), and the variability in leverage between funds. I have created a simple approach to respond to those concerns. To judge the relative risk and yield of these funds, I looked only at the component of distributions that is attributable to traditional income streams (stock dividends and bond coupons). To this end, I based my analysis on the income-only yield data for CEFs compiled and tracked by CEFA. This allows us to look at the yield-versus-risk of a CEF to provide a baseline comparison to other income-generating asset classes.
One of the challenges in assessing CEF yields is how they are expressed. Morningstar, for example, annualizes the most recent distribution (as opposed to looking back over the last 12 months) and then calculates distribution yield from this annualized value and the current price of the CEF. CEFA, for its income-only yield, uses net income figures from the latest annual report divided by the average net assets in the fund. Both of these are reasonable approaches, but they may differ substantively if the income from a CEF varies significantly from year to year, or through the calendar year. The goal of both methods is to create a consistent projection of income, but there may be circumstances in which the most recent year’s income is not a good predictor of the next year’s, or there may be those in which annualizing the most recent income payment is a poor predictor of the entire year. I have created an additional check of both approaches simply by looking at the income distribution for 2011 (the most recent full calendar year) and the current price.
I selected those CEFs with (a) the highest values of CEFA’s income-only yield and (b) at least three years of history. The income-only yield provided by CEFA is based on net asset value, rather than market price of the fund shares, so I adjusted to the yields based on current market prices to create a yield that is the equivalent to the way that yields are expressed for other assets. I also subtracted the expense ratio of the fund from the yield.
I ran a Monte Carlo simulation to generate risk projections for each fund, ranking the CEFs on the basis of the ratio of yield-to-risk, using the net income-only yield, minus expenses. Among the 20 CEFs with the highest yield-to-risk ratio, I computed an income yield based on market price using the recent closing price of each CEF and the income portion of the total distribution from Morningstar. I was principally interested in identifying funds that seemed to have substantially lower incomes for the YTD or the most recent distributions than they had previously, because that indicates the fund is less likely to generate consistent income.
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