UTG：质疑持有该基金的原因

UTG is a popular utilities fund that bests the sector in total return since inception, has a below-average expense ratio and boasts steady increases in distributions.\n

We explore the typical reasons why investors hold the fund: total return, income and stewardship.\n

We find that the these reasons do not hold up - the fund no longer outperforms key benchmarks, has a middling income level and an NAV drag from repeated offerings.\n

The Reaves Utility Income Fund (UTG) is a fund keenly followed by many CEF and income investors. No wonder - it has many apparent virtues. The fund features a below-average expense ratio, it is the best-performing utilities sector CEF since inception and it has recently upped its distribution to the highest level since the fund's inception.

In this article we try to systematically address the arguments for holding this CEF. We use the discussion to investigate some broader questions around CEF ownership, particularly as it relates to the ETF wrapper alternative. We investigate three broad reasons why investors choose to hold the fund - total return, income and stewardship.

We conclude that despite its headline virtues, a deeper dive into these three aspects do not hold up. We find that the fund has failed to sustain its strong performance in the early years post the crisis, does not outearn its ETF counterparts and has repeatedly eroded NAV and price returns via its rights offerings.

One attractive selling point for UTG is that since inception the fund outperforms the utilities ETF benchmark XLU on a NAV basis by over 1% per annum and the S&P 500 by about 2.5% per annum. Since single data points often fail to capture the more nuanced actual investing experience, let's see if we can analyze the fund's performance a bit more closely.

We have to confess our priors here. Our general experience is that equity CEFs tend to struggle to outperform their ETF benchmarks. Why this is the case probably deserves a separate article or two but we think it's primarily due to the fact that consistent outperformance in active management is pretty hard, particularly in stocks.

We tried to quantify this dynamic a few weeks ago in the CEF space by looking at the percentage of CEFs that outperform same-sector benchmark ETFs. Although the comparison isn't perfect we think it actually favors CEFs which can use leverage and hold wider mandates. So, the fact that the majority of leveraged vehicles with more flexible mandates and the benefit of active management have underperformed unleveraged passive ETFs during a bull market decade is surprising.

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Let's see what this looks like in the utilities sector where UTG operates.

The results are not overly encouraging though not disastrous. Just two funds: (GUT) and (UTG) outperform XLU since the start of the century on an NAV basis. Blue dots in the chart mark new utility CEF IPOs. So, despite an ability to use leverage (which was practically free for a large part of the post-crisis period), a broader mandate and active management, only two funds were able to beat the passive benchmark.

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Total return, however, can be a fickle metric. Since most current investors in UTG probably haven't held this fund since inception, shorter-term total return periods are more likely to be relevant and reflective of their holding experience.

To investigate this, we take a closer look at UTG NAV returns over various holding periods which we plot in the chart below along with the rest of the CEF sector and XLU. Over the last 10-year period (green bars), UTG blows XLU out of the water. Over a 7-year period (orange bars), it's still outperforming but the gap is much smaller. Over the last 5-year period (blue bars), however, UTG underperforms. This is unexpected - the last 5 years saw an annualized return of 10% in utilities and in the S&P 500. For a leveraged vehicle to underperform in this environment is just plain odd.

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Arguably XLU is not the right benchmark because UTG allocates to other sectors as well, most notably, telecommunications, media, REITs and others. If we compare its performance against SPY, though, the results are not much better. UTG underperforms SPY by 2.5% per annum over the last 7 years, though, as is the case with XLU, UTG outperforms SPY since inception as well.

So there looks to be a relative performance shift sometime between the last 5 and 10 years where the fund's torrid outperformance shifted to underperformance. To gauge what's going on let's have a look at year-by-year returns.

Annual NAV returns show that in 4 of the last 6 years, UTG has underperformed XLU.

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Another way we like to visualize relative performance is by plotting 1-year rolling return differentials. The chart below captures what seems to be going on. There was a period of about 2-3 years after the crisis when the fund just crushed XLU and SPY. Since then, however, its relative performance has been pretty subpar, significantly underperforming both XLU and SPU over the last 5 and 7 years respectively.

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The fund's sharp outperformance in the post-crisis environment has, in effect, remained with the fund and still drives its excess total return since inception. It's not completely clear why the fund has underperformed in the last 5-7 years. Perhaps, its ability to deliver absolute and relative outperformance could only come through in a distressed-value environment or perhaps its factor and risk exposure tilts have stopped working.

UTG is a good illustration of how it can be difficult to find equity CEFs that will deliver consistent outperformance against passive vehicles. In our experience, fixed-income CEFs tend to do a better job of delivering sustainable outperformance for a variety of structural reasons.

One irony of the fund's post-crisis outperformance was that UTG was an unlikely fund to have picked in a post-crisis environment. The fund had suffered a nearly 70% total return drawdown (and worse on a price basis), so there were probably few investors who had held the fund calmly through that drawdown. And to have selected this fund after such a drawdown would have required perhaps uncanny foresight and rationality.

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Up to now we've compared UTG on an absolute basis which isn't quite apples to apples given UTG is a leveraged fund. Since about 2011, the fund has had a loan facility in place at a cost of 1-Month Libor + 110 after having redeemed its preferred shares.

What we do in the chart below is create a total return series for 20% (being a conservative estimate of average leverage held by UTG) leveraged versions of XLU and SPY (called "LEV SPY" and "LEV XLU" in the chart) at the same cost of leverage paid by UTG. The results below show (the legend is sorted in order of total return) that once adjusted for leverage, both SPY and XLU significantly outperform UTG on a price and NAV basis. So, once we adjust for the leverage and leverage cost employed by UTG,

the fund's outperformance extends even further than just the last 5-7 years

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At this point, we hear many investors say, "OK fair enough - thing is I don't own a utility CEF for total return, I own it for income". So, let's have a look at the income part of the equation.

It will not come as news to fund investors that equity-linked CEFs tend to make distributions out of sources other than earnings. This allows CEFs to support distributions rates well above typical equity low single-digit dividend yields.

Judging by the latest annual report, UTG has a portfolio yield of about 3.52% as of the report date (this is now a bit lower as asset prices have rallied since then). Leverage pushes this to 4.56% and total expenses (broadly speaking fund fees and leverage costs) push this down to 2.65% NII (Net Investment Income) yield which is the figure that investors are effectively earning on their assets. We present the drivers of the fund's yield in the chart below.

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This calculation provides some insight into what sort of income the fund delivering vs. the risk it is taking. First, leverage costs eat up about 80% of the additional income provided by the leverage. So, what this means is that investors are taking about 25-30% additional risk (which would normally add 1.05% of additional yield in the unleveraged or fully-funded form) but

receiving only 0.25% of additional yield for that risk

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The other interesting finding from the chart is that once we add all the fund costs to the additional yield provided by leverage we go from the original portfolio yield of 3.52% to the final fund yield of 2.65%. This means that by owning the underlying assets via this fund wrapper,

investors are giving up a quarter or nearly 1% of the original yield provided by the portfolio

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How does the 2.65% NII yield of UTG compare to benchmark ETFs? The median TTM yield of the top 5 utilities ETFs by AUM is 2.63% with the median fee equal to 0.13%. The conclusion here is that for all the additional leverage taken by UTG,

the fund actually earns a yield in line with sector ETFs

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A common retort we often hear to our complaints about CEF earnings and distributions is that actual earnings don't matter, what matters is current yield. In other words, it is a good thing that the fund kicks off capital gains as part of its distribution. We've never been completely comfortable with this argument for a number of reasons. First, it seems odd on the face of it to let someone else decide when to crystallize capital gains on the assets that you yourself own. It would be an amazing coincidence for the fund to sell the exact right level of assets as the individual investor would herself.

Secondly, for investors holding the fund in taxable accounts, the fund effectively decides when to create a tax event for investors, again taking this decision out of their hands.

Thirdly, we wonder what would happen during a few lean years of flat or negative equity returns when the fund doesn't have capital gains to distribute. Presumably it would fall back on distributing ROC without the capital gain kitty to fall back on. There is nothing necessarily wrong with distributing ROC but it would show that the ability of the fund to fund and increase its distributions is largely a function of market strength rather than any uncanny ability on the part of its management.

One refrain we often hear about a particular fund is that the fund "has done well by me" or something to that effect. We are not always sure what this means exactly but we take it to mean something larger than just total return and income. Let's call it stewardship.

One interesting feature of the CEF wrapper is that the fund's management can drive returns outside of its investment portfolio. For example, management can carry out ATM offerings if the fund is trading at a premium and buy back shares when it is trading at a discount, both of which add to NAV. This aligns the interests of both management and shareholders and should theoretically be appealing to everyone.

The trouble is that this doesn't always work out in practice because of another powerful management incentive - fees. Given that so many CEFs trade at a discount it's perhaps puzzling why they are still trading at all given that management should have just bought back all the shares and delivered a quick boost to shareholder returns. The thing to keep in mind is that the more shares the management buys back the fewer assets there are to accrue advisory fees. So, perhaps, it's not surprising that share buybacks don't happen all that often and when they do it's often on the back of activist prodding.

So, if there is a disincentive to reduce assets, there is an incentive to increase assets. This is often done with rights offerings. However, given that CEFs tend to trade at a discount, executing a rights offering at a discount is going to be dilutive to NAV. Clearly, funds try to avoid flagrantly dilutive rights offerings so they try to time such offerings when discounts are minimal. In fact, some enterprising funds even try to increase distributions to tighten discounts in expectation of an offering.

The arguments used by funds to justify dilutive rights offerings are two-fold. First, they argue that raising cash is important to achieve economies of scale and secondly, they occasionally argue that the cash is needed for some potentially attractive market opportunity which the fund wants to capitalize on.

Which brings us to UTG. UTG has carried out three dilutive rights offerings since 2012. By our calculation the total dilution to NAV has been just under 8% which works out to about 1% drag per annum.

What about the timing of the offerings? Below we plot the authorization dates for each vs. the fund's discount. The chart tells us two things: first, the offerings appear to be timed when the discount is close to a medium-term high. This makes sense given the desire of the fund to minimize the dilution. And secondly, the discount typically widens right after the announcement. What's interesting is that the level of the widening has been significantly greater than the amount of the dilution.

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What about the reasons for the offerings? We were only able to find a comment about use of proceeds for the 2017 offering but it does suggest that the motivation for it was not an immediate market opportunity. This suggests that the relationship between the timing of the offerings and discounts was not entirely coincidental.

Source: SEC

This lack of an obvious market opportunity, however, points to a potential cash drag as the team waits for the cash to be invested in appropriate assets.

To conclude this section it appears that each rights offering carried out by UTG has had three negative implications for investors. First, each offering resulted in a dilution of NAV, equal to roughly a 1% annual drag. Secondly, the discount impact of the rights offering was about a 10% widening which lasted for at least 18 months and, presumably, there was some cash drag while the market opportunities waited to "present themselves".

Another potential argument for holding a fund like UTG is the desire to have access to the management team. This is often the sentiment that drives investors to allocate to fixed-income funds managed by PIMCO.

So if investors want to maintain utilities exposure managed by Reaves outside of the CEF wrapper, they can invest in the Virtus Reaves Utilities ETF (UTES). This ETF is actively managed and has a 0.49% expense ratio with a 1.94% yield. UTES has bested UTG on price and NAV basis since its inception.

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Let's recap the three main reasons why investors hold UTG. Holding the fund for total return faces the difficulty of the fact that the fund's NAV has underperformed major benchmarks like XLU and SPY over the last 5-7 years on an absolute basis and for longer once adjusted for the additional leverage. Holding the fund for income faces the difficulty of UTG earning less than some utility ETFs with the fund giving up a quarter of its portfolio yield through fees. Holding the fund for stewardship faces the difficulty of the 1% annual drag from three rights offerings.

So, what are the actual reasons for holding the fund? Well, one way to gauge investor actions is through revealed preferences and we think that those investors holding the fund are doing so because they want a leveraged play on utilities and a few other sectors for diversification because of a bullish market or sector view. There is absolutely nothing wrong with this. It is worth keeping in mind, however, that there is an common bias in investing which arises from a leverage constraint that causes investors to chase expensive leveraged or high-beta assets that subsequently end up underperforming.

Another lesson of UTG is that total return investors should focus on consistent performance to avoid a situation where they hold the fund that had a stellar couple of years a decade ago that has since reverted to the mean or to underperformance.

A final lesson is that leveraged vehicles are not guaranteed to outperform their passive counterparts even in a bull market. We think this is the case for a number of reasons: 1) active management is hard, 2) high fees make it even harder and 3) dilutive actions on the part of management make it that much harder.

To avoid being complete naysayers, we think there are some positive steps that investors can take. Those investors who don't particularly need the additional leverage should explore passive ETF benchmarks as valid alternatives for both total return and income which don't have the pesky incentive drags. Those investors who do want the additional leverage, however, may want to leverage the ETFs themselves. The leverage cost of doing so is not much more expensive than what is paid by funds like UTG (and could actually be cheaper above a certain margin loan amount) and the absolute and risk-adjusted performance may end up being better because of significantly lower funds fees and the avoidance of additional volatility due to CEF discounts.

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.