The Ups And Downs Of CEF Investing - Author Interviews

After the success of last year’s author interviews, I have once again surveyed some of Seeking Alpha\'s Closed-End Fund experts and authors.

The responses reveal even more of the nuances of investing in closed-end funds.

This study highlights the fact that investors with different investing objectives can experience noticeably different outcomes and perceptions.

I recently conducted another set of "virtual interviews" with some of Seeking Alpha's Closed-End Fund experts and authors about CEF investing. Although we did not explore these assets in-depth, I believe these insights will benefit our readers by touching on some of the pros and cons involved with closed-end funds. The responses here are from each author’s personal experience.

Those interviewed were asked to briefly answer the following questions:

(Please note that some of the following responses have been edited for clarity and/or brevity.)

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Systematic Income

1) We are investment-vehicle agnostic and not overly wedded to CEFs or any other fund structure. Our research suggests that CEFs tend to outperform other fund vehicles like ETFs and mutual funds in income-sectors such as credit and preferreds. Equity CEFs tend to underperform passive benchmarks. This is because, for various market structure reasons, outperformance in equity-linked sectors is much harder to come by than in debt. So the evidence tells us that for equities we would almost always use ETFs, and for hybrids/debt we use CEFs when attractively valued.

2) I would say our biggest mistake was being insufficiently bold in aligning our investing with our research. We tend to be relatively cautious and focused on capital preservation but occasionally you really do have to take the fat opportunities that the market gives you. The CEF market is still fairly inefficient, which means there is a real edge if you are willing to look for it.

3) We don't offer a single CEF portfolio simply because we don't believe a single portfolio could possibly work for all investors. Instead, we offer a menu of tools from which investors can pick and choose that includes systematic investment strategies, volatility-optimized yield-target portfolios, sector fund screens and others.

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Too Greedy for Adam Smith: CEO Pay and the Demise of Capitalism

1) My Income Factory™ strategy is all about using high current yields to create a “river of cash” that you can re-invest and compound to create your own long-term growth through all sorts of market conditions. I look to the closed-end fund market almost exclusively for income.

Of course CEFs are the perfect investment for doing that because you avoid the “run on the fund” risk that can plague open-end funds, which allows you to buy less-liquid asset classes like HY bonds, senior secured corporate loans, MLPs, CLOs and others that often pay high cash yields but are more complex or thinly-traded. These are the sorts of assets that often continue performing and paying their distributions through market downturns, but sell off in price because retail purchasers lose their nerve and head for the sidelines at the first whiff of trouble. In other words, precisely the times you want to hunker down, hold on and reinvest your distributions at bargain prices. Closed-end funds allow you to do that.

CEFs also allow you to buy high yielding asset classes at discounted prices, so you can have 100% of an asset working for you and paying you a distribution, but you only may have paid 90 or 95 cents on the dollar for it.

2) As for my biggest mistake, ask my readers, since I make my mistakes in public and report on them on Seeking Alpha (“eating my own cooking, in public,” I call it). But probably my most memorable mistake was buying the Third Avenue Credit Fund a number of years back. It was a fund that planned to buy high yield distressed credits. Highly illiquid, but a big payoff if you buy them at the right time and know what you’re doing. Unfortunately, when the market for high yield tanked, investors in the fund panicked and sold, which meant, as an open-ended fund, it had to sell assets and redeem the shares of the departing stockholders. This “run on the fund” essentially killed it and it collapsed. Had it been a CEF, I’m sure the fund would have suffered a big drop in price, but would have survived. In this case my big mistake was not recognizing that NOT being a CEF made this fund far more dangerous than it would have been had it been a CEF. So it was a mistake that demonstrated to me the advantages of CEFs in a very tangible and visceral way.

3) The biggest breakthrough in my own thinking about investing was my “discovery” of what has become my Income Factory™ strategy. I realized that paper gains and losses are pretty meaningless once you define your goal as building and growing your income stream (i.e. the “output” of your factory), and that the changes in the market value of the factory itself were hardly important in an economic sense. (For instance, Ford Motor doesn’t worry much about what its factories are worth on the open market; they worry about how many cars they produce).

The other breakthrough was realizing that it is less risky and a less “heroic” investment bet to invest in credit instruments than in equity. In a credit bet (loans, bonds, etc.), you win the bet as long as the company stays in business and pays its debt. In an equity bet (i.e. buying the stock) the company has to not only stay in business, but has to excel and grow its business and earnings. Merely surviving doesn’t do much for stockholders, who take the same risk as creditors (if the company folds, the stockholders lose everything, while creditors may get back 50 cents on the dollar or so). So it makes no sense to buy the stock unless you are sure you’ll make considerably more than creditors, who are taking far less risk. I call this choice “betting on horses to merely finish the race” (i.e. credit) versus “betting on horses to win, place or show (i.e. equity).

1) Closed-End Funds can be used mainly as an alternative to what their assets have to offer if and when a CEF is undervalued or as a hedging tool when a CEF is overvalued. Buying and holding a CEF, in general, is a poor strategy. There is a lot of academic research on this matter. The hidden value of CEFs is when a person takes advantage of the mispricings. I personally use CEFs to generate Alpha on big market moves when a certain CEF has overreacted.

2) My biggest mistake was to short overvalued CEFs. The broad public fails to realize the mispricing as long as the dividend is not cut and a short seller has to be very accurate with the timing.

3) Hard work is the only way to be successful. Communicating with more knowledgeable people has also helped me a lot and prevented me from making enormous losers. The Seeking Alpha community can be of great help to anyone willing to learn and improve.

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1) I use them solely for growth. I hold high-yield CEFs exclusively in IRAs and reinvest the distributions directly back in the fund. I am hoping to have built up a sizable nest egg through which, when I do retire, the income stream will supplement other retirement income sources.

2) My biggest mistake was chasing yield/performance. At first, I was so attracted by the high yields offered that I did not worry enough about the price I was paying to get into the fund. Watching a share price rise while sitting on the sidelines can be hard to do, but chasing after past performance can have poor results sometimes. I am now much more disciplined with my entry points and, if a fund simply does not have the right valuation, I sit and wait for a better opportunity. Plenty exist within the CEF space, so letting one get away does not equal failure, in my opinion.

3) A factor that has led to a successful portfolio is understanding what the underlying assets are and understanding the outlook for those assets - what conditions currently exist that make it a profitable opportunity. It is easy to look at the obvious characteristics - yield, premium, year-to-date performance, and just go with it. Investors need to take the time to understand what is in the fund - whether its muni debt, mortgage debt, high yield corporate, emerging market sovereigns, and decide if that is the right exposure for them. For instance, I have been recommending muni debt for some time, but that may not be the right asset class for investors in low-tax states, or who have low-moderate incomes. I personally am heavily invested in the mortgage debt space, as the U.S. housing market has shown impressive resiliency.

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CEF/ETF Income Laboratory

1) I use CEFs as sort of a growth and income strategy. Yes, it's very common to use CEFs as income because of their higher than typical distribution rates. However, I collect all the distributions and use those funds to continue to purchase more shares of CEFs that I feel are attractively valued, thus "growing" my portfolio's value and income at the same time.

2) The first CEF I ever purchased was my biggest mistake. I bought

IGD

around early 2010 or so, which is now named Voya Global Equity Dividend & Premium Opportunity Fund (previously it was ING Group until ING U.S. changed its name to Voya). At that time I knew very little about CEFs and just saw an over 10% yield and thought I found a gold mine! I didn't bother reading Annual Reports or seeing what the fund owned, I didn't need any of that at that time!! Well, in my ignorance, the fund cut the distribution 3 times over the next couple of years, and as I was learning more and more, I was starting to realize that IGD was an awful fund in respect to distribution safety and fund composition. At that time it didn't even have a significant discount to warrant purchasing either. I eventually sold IGD and bought several other funds that were much better off. I haven't looked at IGD since, so this isn't an indication of how I feel about the fund at this time.

3) I believe that for me, there were multiple things that really helped me along the way. After purchasing IGD and not having success with that fund, it drove me to actually learn about investing in CEFs instead of getting frustrated and walking away. I remember also running into a lot of Seeking Alpha articles that were very informative, so I do owe SA and the community a ton of credit for helping educate me.

And also for me personally, I believe it has helped that I usually shy away from funds that have a distribution of 10% or more. At least I give them greater scrutiny and they don't comprise a large portion of my CEF portfolio. The funds I generally stick to are right around the 8-9% yield mark, which to me, is still plenty high enough.

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Yield Hunting

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1) Honestly, to us it doesn't matter if it’s growth or income. We look at a total return opportunity and, while most of the time the large majority of that is from 'income', we do derive some gains by buying opportunistically. Over the last twenty years, CEFs have migrated towards an income-based distribution policy as that is what the shareholder base has demanded. We think the trend will remain towards higher payouts (managed distribution policies) and monthly frequency. That is what the market is saying it wants.

2) Our biggest mistake was not taking into account the macro picture enough. For instance, we were too heavy into muni CEFs back in 2013 and 2014 despite the rising rate environment. However, muni CEFs were extraordinarily cheap but just got cheaper as money flow was out of these funds. CEF shareholders are the ultimate sentiment indicator and the fear at the time was that we were in a FAST rising interest rate environment. By not fully accounting for that sentiment factor, we saw inferior returns.

3) The largest impact we have made is simply by going slow and being more methodical. Building in a systematic research process through monthly reports has helped to hit all aspects of due diligence more regularly. We try to incorporate that into our service through our weekly Sunday commentaries and through our monthly reports.

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1) For our individual account clients, CEF Advisors focuses on customized high-touch income portfolios, typically balancing the Beta (volatility vs S&P 500), Duration (sensitivity to interest rate changes), and Correlation of holdings and sectors (relationship of a portfolio's holdings / sectors to each other). For taxable accounts, we review the portfolio for after-tax yield and estimate tax-friction. Of course, we monitor our total return net fees vs expected goals and vs an appropriate selection from our 35+ CEF/BDC indexes.

For our CEF/BDC/iCEF selection process, we utilize a Trifecta analysis: Assessing our experience and opinions on NAV direction, Discount direction and Dividend direction (sustainability), we build portfolios of 25-40 funds to fulfill client goals. We find that income-only analysis can be misleading if you forget to analyze the NAV, manager, and historical and expected discount ranges.

2) My biggest mistake was that, early in my career, I believed dividend policies as being “more secure” and a recurring expectation for clients’ income needs than ended up being true. With changing market economic cycles and interest rates, we found that historically, dividends go up or down for 90%+ of funds in a 3-5 year period. Some are small changes, however, some are large, and this can throw a portfolio off track for a client’s income needs.

Another mistake we made in the past was when we traded on large discount moves (low in a historical discount range or just large negative Z-stats) thinking it identified funds currently and historically cheap. However sometimes the downward price moves had little likelihood of ever returning to previously higher levels. We had to add some human review to these expectations.

3) The biggest impact to our success has been our ability and interest to connect and stay-in-touch with peers, sponsors, analysts and product developers in the CEF/BDC space. With our newsletter in the past, and now our data business, we have been able to straddle the line of press, analysts, advisor and portfolio manager. Second to that, I remind people that the funds are 90% traded by retail investors and that previous rules can and will change so be prepared to react and adjust your investment criteria. If it were easy, the large quant hedge funds would have removed the inefficiencies already.

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Perpetual Income With Closed-End Funds

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1) I invest in CEFs for perpetual income. I use the reinvested distributions and the rebalancing of positions to grow both the value of my portfolio and the income stream it generates. Once I retire, I’m only interested in the income stream.

2) In reviewing my biggest investing mistakes, I realized that any positions I’ve had that crashed and I lost a lot of money on were REITs, MLPs, or mutual funds. I would have to say that, so far, my biggest mistakes with CEFs were the times I sold a fund in a panic, only to regret it a short time later after it recovered. Because of that, now I make myself wait before selling a fund I may have concerns about. Sometimes I end up losing some money, but other times I’m glad I held tight. As long as the overall portfolio is holding steady or trending up over time, that’s what’s important to me.

3) Early on in my CEF investing, I discovered the beauty of rebalancing and how it could stealthily grow my income-producing shares, and I stay committed to that strategy today. Another thing that has helped a great deal is constructing an investment plan that is simple and easy-to-follow so that I don’t tire of making decisions all the time. And while rebalancing positions has been a key factor in growing my CEF portfolio, doing it too often wasn’t beneficial, and may even have hurt at times. Setting up more definitive thresholds as part of my simpler plan has made this task much easier and has decreased the number of transaction fees involved.

What I appreciated most about this exercise is that it demonstrates how persevering after mistakes and failures lead not only to a better understanding of investing, but also lead to developing each investor’s own strategy and investment philosophy. The mistakes were formative in each one’s perspective, and subsequently, their successes in investing with closed-end funds.

Thank you to everyone who participated in this survey. I hope our readers have found some benefit in reading it.

Be sure to check out these authors' writings and resources.

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I/we have no positions in any stocks mentioned, and no plans to initiate any 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.

Additional disclosure:

Nothing in this material should be taken as a recommendation or financial advice. Your situation will be different from those of the contributors to this article. Please do plenty of due diligence before embarking on any investment strategy.