Best Closed-End Funds
July 24, 2012
Several features of this chart are striking. First, those 20 CEFs are more attractive than most other CEFs, even though all of the funds were selected on the basis of high income-only yield. Potential investors need to look well beyond raw yield numbers in their search for an appropriate fund.
The yields and risk for the top 20 funds have a roughly linear relationship, and the funds with the lowest yields and lowest risk levels are comparable to high-yield bonds. Conceptually, this makes sense. The high-yield bond ETF is un-levered, and could be leveraged to increase yield but only with a commensurate increase in risk.
Conclusions
While unfamiliar to many advisors and investors, CEFs offer attractive values in the current environment. Their yield-versus-risk profile positions them as a viable alternative asset class in investors’ long-term portfolios, especially when compared to strategies such as hedge-fund replication.
When evaluating CEFs on the basis of yield-versus-risk, I adjusted for the fact that not all of the distributions are equivalent to income. The process of estimating income-only yield is, however, straightforward. The CEFs with the highest income net of expenses relative to their risk levels are the most attractive. The highest-yielding among these have income levels around 10% per year, with risk levels close to those of the S&P 500.
An equal-weighted portfolio of the 20 CEFs with the highest income yield-to-risk ratio would have an income-only yield of 8% and a projected volatility of 15.1%, roughly equivalent to the statistics for a portfolio that is 70% allocated to the S&P 500 and 30% allocated to an aggregate bond index. But a 70/30 portfolio has yield that is just above 2%. The 8% yield from the equal-weight CEF portfolio is very attractive, even in the context of total return. A 70/30 portfolio, to put it bluntly, does not have an expected total return of 8%.
A recent paper argues that constraints on the use of leverage led to the mispricing of assets, such as CEFs. Given the high yield–versus-risk for the more attractive CEFs, the widespread use of leverage may be allowing these funds to exploit this arbitrage opportunity. According to Morningstar, more than 70% of CEFs employ leverage. Particularly in the current low interest rate environment, CEFs can boost income because leverage is so cheap.
An 8% yield for the same volatility as that of a 70/30 portfolio may seem too good to be true. Are there additional risks that are not captured in the historical and projected volatility, thereby justifying the high yields? Given that there is no consensus opinion that explains CEF premiums and discounts, and that this effect is a true anomaly in finance, it is certainly possible that there are some special risks that our volatility projections may be missing.
One potential source of risk is the ability of a CEF to maintain its distributions. While there are long-term studies of the consistency of dividends from stock and coupon payments from corporate bonds (both investment grade and junk), research is lacking on this topic for CEFs. My cursory examination of the distribution history of CEFs makes it clear that distributions can vary greatly from year to year. But in theory, of course, such variability should be reflected in the volatility of the CEFs’ prices.
Investors challenged by the current low-yield environment will be well served by allocating a portion of their portfolios to carefully chosen CEFs. While a foray into this class of funds requires familiarity with some new terminology and features, this is an investment of time and effort that is well worth making.
Geoff Considine is founder of Quantext and the developer of Quantext Portfolio Planner, a portfolio management tool. More information is available at www.quantext.com.
Geoff’s firm, Quantext is a strategic adviser to FOLIOfn,Inc. (www.foliofn.com), an innovative brokerage firm specializing in offering and trading portfolios for advisors and individual investors.
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