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Summary This High-Income, Stable-Capital CEF portfolio is designed to generate current income with reasonable tax efficiency. The portfolio’s second, and equally weighted, objective is long-term sustainability of capital. The objectives are addressed by entering positions in quality funds when their discount status is attractive. This article summarizes the final quarter of 2015. High Current Income and Capital Stability from CEFs At the end of 2015’s gut-wrenching third quarter (chart at right) I took note of the sharp declines in closed-end funds and considered that an opportunity was at hand. I proposed a portfolio of CEFs ( A CEF Portfolio For High Current Income With Capital Preservation ) designed to generate high current income with capital sustainability: The Stable-Capital, High Current-Income Portfolio. With the fourth quarter in the books, it’s time to review the results. I’ll not spend time here rehashing the details of the portfolio; interested readers should refer to the article cited above. But I will say that one incentive for building this model grew from my frustration with the performances of ETFs, ETNs and CEFs that offer portfolios of CEFs. As the name implies, the model has three objectives: First is high yields for current income. I’ve targeted 8% for taxable funds and 5% for tax-free municipal bond funds. Any excess is to be reinvested. Second is sustainable principal value. Capital growth is not an explicit objective, but maintaining a sustainable principal while withdrawing income at approximately 7.6% will obviously require periods of capital growth to offset inevitable periods of capital erosion. Third is tax efficiency. I wanted a manageable portfolio, so I limited the selections to 15 funds and equally weighted them. The portfolio is diversified across income asset classes. The funds selected are: Equity (40%) Dow 30 Premium & Dividend Income Fund Inc. (NYSE: DIAX ) Eaton Vance Tax-Managed Global Buy-Write Opportunities Fund (NYSE: ETW ) Eaton Vance Tax-Managed Diversified Equity Income Fund (NYSE: ETY ) Tekla Healthcare Investors (NYSE: HQH ) NASDAQ Premium Income & Growth Fund Inc. (NASDAQ: QQQX ) Columbia Seligman Premium Technology Growth Fund, Inc. (NYSE: STK ) Real Estate (6.7%) Cohen & Steers Total Return Realty Fund Inc. (NYSE: RFI ) Preferreds (13.3%) Flaherty & Crumrine Preferred Securities Income Fund Inc. (NYSE: FFC ) First Trust Intermediate Duration Preferred & Income Fund (NYSE: FPF ) Fixed Income – Taxable (26.7%) Western Asset Mortgage Defined Opportunity Fund Inc. (NYSE: DMO ) PIMCO Strategic Income Fund, Inc. (NYSE: RCS ) AllianzGI Convertible & Income Fund (NYSE: NCV ) PIMCO Dynamic Income Fund (NYSE: PDI ) Fixed Income – Tax-Free Municipal Bond (13.3%) Eaton Vance Municipal Bond Fund (NYSEMKT: EIM ) MFS Municipal Income Trust (NYSE: MFM ) Comparables The comparables I’m using for this portfolio are: Cohen & Steers Closed-End Opp (NYSE: FOF ), an unleveraged closed-end fund of funds with 85 CEFs in its portfolio. PowerShares CEF Income Composite (NYSEARCA: PCEF ), an unleveraged ETF holding 147 closed-end funds. UBS E-TRACS Mthly Pay 2x Closed End ETN (NYSEARCA: CEFL ), an ETN (Exchange Traded Note) indexed to a 2x leveraged portfolio of 30 closed-end funds. YieldShares High Income ETF (NYSEARCA: YYY ), an unleveraged ETF that holds a portfolio of 30 closed-end funds using the same index as CEFL. Fourth Quarter Results Income The first objective is current income, so let’s start with a look at distributions for the funds. Recall that any distributions for the quarter over 2% (8% annualized) for 13 taxable funds and over 1.25% (5% annualized) for two tax-free, muni-bond funds are retained for reinvestment. (click to enlarge) Total distribution was $3430.00, a return of 3.26% for the quarter. The return is enhanced by three funds posting special distributions. PDI added $2.61/share for $608.13; DMO added $1.20/share for $322.80; and RCS added $0.04/share for $32.28. Thus, special distributions put an extra $963.21 or 28.08% to the quarter’s yield. When only the regular distributions are considered, the portfolio paid $2466.79, which exceeds the anticipated $2,372.43 by 4% (see previous article for a discussion of anticipated yields). Distributions for all but three funds met the 8%/5% target. The shortfalls were minimal and were anticipated at the onset: DIAX -$10.60, FPF -$31.10, and QQQX -$14.62. Overall, the 8%/5% target objective was exceeded by $1,428.03, which is available to reinvest. At the quarter’s close, yields for the funds are as shown in this next chart. (click to enlarge) As we see, a few have increased but most now have decreased yield percentages, reflecting changes in market prices. This leads to discussion of the next objective: stability of principal. Price Performance and Capital Stability It was a good quarter for the portfolio. Somewhat surprisingly so, in fact, considering the generally poor performance of equity and fixed-income markets. Here is the market price performance for the portfolio’s funds. (click to enlarge) Only four funds had price declines. For two of these, PDI and DMO, the declines were partially a consequence of their high special distributions. One, FPF, is essentially flat. And one, NCV, is the portfolio’s big loser having given up 4.5%. I added NCV to the portfolio because I felt that it was due for a move up. It had just come off a large dividend cut and moved from a perennial premium to a discount of -15%. The fund was paying a 13.44% yield. I anticipated the discount would be reduced and the fund would stabilize at a somewhat higher valuation to NAV. This has happened; the discount is now -11.2%, but NAV has been falling along with the rest of the high-yield bond market. The fund does, however, continue to pay an exceptional distribution (14.1%). Two funds that have been long-time favorites of mine, STK and HQH, had stunningly good quarters; they’re up 13.8% and 12.1%. I’ve written on both of these several times over the past couple of years, and regular readers are aware of my high regard for both of them. HQH had been unduly beaten down. As the biotech sector dropped mid-year, HQH dropped even further. This is yet another example of the exaggerated panic selling so often seen in closed-end funds. STK was also oversold in response to the summer’s market upheavals in technology. It fell to a -6.2% discount at one point, but was back up to a 2.4% premium when I began this portfolio. Anyone who was quick enough to grab that -6% discount gets my admiration and compliments. Premiums and Discounts Let’s look at the changes in discount/premium status for the funds which provides a bit of an object lesson in CEF investing. (click to enlarge) In large measure I felt that these funds were undervalued and oversold at the end of September. As such they offered especially attractive entry points. As we see here, only one fund (NYSE: DMO ) has not gained value from a favorable move in the discount/premium. Two, FFC and RCS, have grown from moderate-to-modest discounts to substantial premiums. I held both of these at the time I started this exercise. I’ve since sold FFC (and anticipate replacing it with FLC or, perhaps, another preferred share fund) to take advantage of that profit and have been considering doing the same for RCS. RCS is a fund that has run a perennial premium. It dropped to a discount after PIMCO cut distributions on several of its high flyers (not, however, RCS). I felt that RCS’s drop was unwarranted at the time and it quickly turned around. I will likely echo my real-money swap of FFC for another preferred shares fund in this model portfolio once I’ve reviewed the space. It could be FLC here as well, but there are other strong contenders which may be a better fit. Preferred shares are presently a bit of a hot asset class, so everything out there (except FPF which is already in the portfolio) is above its mean discount status. I’ll add here a view of the Z-Scores for the funds from the beginning and end of the quarter because I think it helps to reinforce the emphasis I’ve been putting on moves in discount/premium status relative to mean discount/premiums. (click to enlarge) On the whole, the 29 September Z-scores were indicating reasonable entries for most of the funds. As I noted at the time DMO, EIM, PDI and STK were exceptions, but I wanted those high-quality funds in here despite those apparently unattractive valuations. Notice too, how frequently the Z-scores predict reversion to mean values. By these indicators, HQH remains an especially attractive opportunity (especially so if, like me, you’re inclined to think biotech is due for a recovery), but little else in the mix is. Indeed, I would not be surprised to see some corrections in the other direction in the coming months. As I noted above, RCS and FFC look ripe for profit taking. The equity option-income funds, DIAX and QQQX, which I also suggested were good buys because of their unjustified under-valuations have moved to highly positive Z-scores as well. The problem with trading out of these funds is that one needs to find a replacement. I’ll be working on that as time allows and as I go through a similar exercise for my own portfolio which shares many of these positions. Performance Summary Fourth quarter performance is summarized in this table. (click to enlarge) As shown, the portfolio is up $5,550.27 (5.5%) on market price. Results for the quarter for some asset-class benchmarks are seen in this chart. (click to enlarge) The portfolio performed well relative to these benchmarks. On price returns it lagged the S&P 500, Russell 3000 index and the Dow Jones REIT index, but it beat corporate and high-yield bonds and preferred stocks. Consider that the 5.5% price return does not include the 3.3% distribution yield, a yield unmatched by any of these benchmarks, and it’s clear that it was a good quarter for the HI-SC portfolio. The next chart summarizes the total returns for combined market price and distribution yields for each fund. (click to enlarge) Only NCV is negative for the combined values. Comparables As noted earlier, there are products that offer exposure to CEFs. I’ve not been a big fan of these, but I know many readers are. Here’s how they stack up for the quarter. Each is based on a $100K investment at the quarter’s start. The table that follows shows percentage return for combined market value and distributions. The chart says it all, in my mind. CEFL, true to its charge and 2x leverage, generated remarkable income. But, true to its ongoing track record, that income has come at a substantial capital cost. It does beat FOF and YYY, as it should with its 2x leverage, but it lags PCEF. The lag is trivial but PCEF is an unleveraged product, so in an up-trending quarter, one would have certainly expected a better showing from CEFL than an essentially even run with the ETF. None of these comes close to the HI-SC returns. I’ll be the first to admit here that the model had an unfair advantage in that it was selected at the beginning of the quarter with valuation as a high priority. But I’d also argue that the model portfolio has a much higher quality of funds than any of the comps here and that is also a consideration. We’ll continue following these funds as I do quarterly updates to see if the outperformance trend continues. Updating the Portfolio As it stands there is $1,428 in excess distribution returns to reinvest. One possibility is to add them to the funds that are the greatest distance from the equal-weighted goal. My typical target for rebalancing a portfolio is more than 10% out of balance. This table shows none at that level, but three over 9% out of balance. If I add a third of the reinvestable capital to each of DMO, PDI and NCV it would bring them closer to equal weighting. A good case can be made for this. DMO and PDI are top-of-their-class funds, but their valuations look pricey at the moment. NCV has, as I noted, been hit hard by the flight from high-yield. Is that due to turn around? I think it might to some extent, but I’m not anticipating a good year for that asset class. And when an asset class falters, the CEFs for that asset class almost invariably exaggerate the declines. The fact that NCV has such a high yield argues in favor of bringing it up to near balance. I also am considering taking some profits and swapping out of some funds. I should have some clarity on that in the coming weeks, so I’ll be holding off on the re-investment until I make those decisions. I’ll update on changes when I make them. If you have suggestions, I’d love to hear your opinions in the comments. Scalper1 News
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