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EOD: This Global Equity Fund Could Bounce Back

Summary 15% Discount to NAV is near 5 Year Highs. High 11% Distribution Rate Combined with Discount Produces Alpha. The fund uses dividend capture and an options overlay to increase distributable income. The Wells Fargo Advantage Global Dividend Opportunity Fund (NYSE: EOD ) is a covered call global equity closed-end fund, created in March 2007, with about $365 Million in assets under management. The primary objective of the fund is to provide a high level of current income, with a secondary objective of long term capital growth. (Data below is sourced from the Wells Fargo Advantage website unless otherwise stated.) The fund is currently selling at a 15% discount to NAV which is near its five year high. Here is a five year history of the premium/discount from cefconnect: (click to enlarge) The Fund invests in global equities with an emphasis on companies with attractive dividend policies and/or those with the potential to grow their dividends over time. The Fund focuses on companies in the utilities, telecom and energy sectors. They also employ dividend capture and an options overlay to increase distributable income. Within the equity covered call CEF sector, I generally prefer funds that use index options over those that use options on individual stocks. Aside from the tax advantage, the options on stock indexes generally trade with a lower bid-asked spread and are more liquid. This means reduced “slippage” costs resulting in less drag on performance. EOD uses both kinds of options. But the options holdings are modest (around 7%) of equity value, so the slippage factor is not a big deal here. As with many covered call funds, the fund uses a high managed distribution plan where they currently are paying out $0.18 per quarter. Five years ago the fund was paying out $0.28 per quarter, but the NAV has fallen because the total return has not kept up with the large distributions. EOD usually “earns its distribution” because of the options overlay and dividend capture strategies, but occasionally will use return of capital if there is a small shortfall. The quarterly distribution was reduced to $0.21 in November, 2012 and was lowered again to $0.18 in November, 2013. The distribution cuts have been successful in preventing major drops in NAV the last three years. This was the top eight country allocation as of July 31, 2015: U.S. 51.3% U.K. 11.4% Italy 8.2% Bermuda 7.4% France 6.8% Canada 5.4% Spain 5.2% Germany 4.2% The top equity sector allocations as of Sep. 30, 2015 are listed below. Note that there was zero exposure to the Basic Materials, Technology, Consumer Defensive or Healthcare sectors. Equity Sector Allocation Utilities 31.8% Real Estate 20.3% Communications 16.1% Financials 11.3% Consumer Cyclical 9.4% Industrials 5.6% Energy 5.5% Source: Morningstar Here is the total return NAV performance record since 2008 along with its percentile rank compared to Morningstar’s World Allocation category.   EOD NAV Performance World Allocation NAV Percentile Rank in Category 2008 -33.55% -39.30% 31% 2009 +13.33% +46.71% 100% 2010 + 3.13% +23.98% 100% 2011 – 4.44% – 3.21% 65% 2012 +9.23% +19.81% 85% 2013 +12.65% +11.07% 85% 2014 + 8.29% + 6.14% 30% YTD – 4.42% + 0.06% 91% Source: Morningstar Here are the top ten holdings for EOD as of Sep. 30, 2015: (click to enlarge) Fund Management Timothy P. O’Brien, CFA: Managing partner at Crow Point Partners LLC. Previously worked with the Value Equity team of Evergreen Investments. Has been in the investment management industry since 1983. Kandarp Acharya, CFA, FRM: Senior portfolio manager at WellsCap. Has a background in quantitative research, development of capital markets expectations, multi-asset class market risk modeling, risk management and hedging and optimization strategies. Christian L. Chan, CFA: Senior portfolio manager at WellsCap. Prior positions include roles as head of investments on several asset allocation funds at Wells Fargo, and quantitative research manager at an institutional investment consultancy. The discount to NAV as of November 6 is -14.83%. The one year discount Z-score is -1.24 and the one year average discount is -10.69%, which means that the current discount to NAV is more than one standard deviation below the average discount over the last year. Source: cefanalyzer Alpha is Generated by High Discount + High Distributions The high distribution rate of 11.46% along with the 15% discount allows investors to capture alpha by recovering a portion of the discount whenever a distribution is paid out. Whenever you recover NAV from a fund selling at a 15% discount, the percentage return is 1.00/ 0.85 or about 17.6%. So the alpha generated by the 11.46% distribution is computed as: (0.1146)*(0.176)=0.0201 or about 2% a year in discount capture alpha. Note that this is way more than the 1.07% baseline expense ratio, so you are effectively getting the fund management for free with a negative effective expense ratio of -0.93%! Ticker: EOD Wells Fargo Advantage Global Dividend Opportunity Fund pays quarterly Total Assets= $361 Million Annual Distribution (Market) Rate= 11.46% Fund Expense ratio= 1.07% Discount to NAV= -14.83% Portfolio Turnover rate= 76% Average Daily Volume= 192,000 Average Dollar Volume= $1.2 million Call Options as a % of total assets= 6.62% No leverage used This looks like a good time to start buying EOD. It is liquid and easy to purchase. Tax loss selling may still be depressing the price, so there may be more purchase opportunities as we approach year end. For those in a high tax bracket, it is probably best to purchase EOD in a tax deferred IRA account since most of the distributions are taxable income. Full Disclosure: Long EOD.

What To Do When Your Stocks And Bonds Portfolio Reaches Minimum Volatility

Summary Investors typically increase exposure to bonds as they near retirement, hoping to reduce volatility and drawdown risk. It is very possible to reach a point where further increasing exposure to bonds will increase rather than decrease volatility. This phenomenon is more likely to occur with longer duration bond funds. Once you reach minimum volatility for a two-fund stocks and bonds portfolio, you can further reduce risk by (1) buying treasuries or (2) switching to a shorter term bond fund. There is no general result for which strategy is preferred, but (2) tends to give better returns and may be easier to implement. Expected Returns and Volatility as you Increase Bond Exposure Suppose you are implementing a basic stocks and bonds portfolio comprised of two Vanguard mutual funds: Vanguard 500 Index Fund Investor Shares (MUTF: VFINX ) and Vanguard Long-Term Bond Index Fund (MUTF: VBLTX ). Using historical data going back to Feb. 28, 1994, here is how expected returns and volatility of the VFINX/VBLTX portfolio vary with asset allocation. (click to enlarge) Here the top-right point represents 100% VFINX/0% VBLTX; the next data point is 90% VFINX/10% VBLTX; and so on until the bottom-most point, which is 0% VFINX/100% VBLTX. As you near retirement, you may increase your VBLTX allocation to reduce risk. If you go from 90% VFINX/10% VBLTX to 60% VFINX/40% VBLTX, for example, you reduce your expected returns a little (0.041% to 0.037%), while reducing volatility considerably (1.06% to 0.70%). Further increasing the VBLTX allocation reduces volatility, but only to a point. At 25.8% VFINX/74.2% VBLTX, you reach the leftmost point on the curve, and further increasing VBLTX allocation actually increases volatility while reducing expected returns. Of course, there is never a good reason to increase volatility and decrease expected returns. So looking back at the past 21.5 years, you would never have wanted to allocate more than 74.2% to VBLTX in a VFINX/VBLTX portfolio. Longer Duration Bond Funds Have Lower Critical Points The expected returns vs. volatility curve doesn’t always have a clear critical point like we saw for VFINX/VBLTX. In general, longer duration bond funds are more likely to exhibit this phenomenon. You can see this when you compare the curve for VFINX paired with VBLTX to VFINX paired with Vanguard’s short-term and intermediate-term bond funds, VBISX and VBIIX . (click to enlarge) Looking at the blue curve, VFINX/VBISX does have a minimum volatility point, but it’s at a very high VBISX allocation (4.3% VFINX/95.7% VBISX). Note however that if you’re using VFINX and VBISX you probably wouldn’t want to go higher than 90% VBISX, as doing so sacrifices considerable expected returns while reducing volatility very little (if at all). The green curve is in between the first two, with minimum volatility at 12.7% VFINX/87.3% VBIIX. I would not recommend going any higher than 80% VBIIX, though, from an expected returns/volatility standpoint. Reducing Volatility Beyond the Critical Point What do you do if you want to further reduce volatility after reaching your portfolio’s critical point? I see two reasonable options: Allocate some of your portfolio to treasuries (e.g. 10-year US treasury bonds). Swap for a shorter duration bond fund. Let’s go back to the first two-fund portfolio, VFINX/VBLTX. Suppose we’re at 25.8% VFINX/74.2% VBLTX and we recognize that we’ve reached minimum volatility. We would like to reduce volatility to one-fourth that of VFINX (the leftmost dotted line in the previous figures, at 0.298). We can’t do it with all of our assets allocated to VFINX or VBLTX. Let’s consider option (1). Allocating some of your portfolio to cash would pull the red curve down and to the left. But if you’re going to have cash, you may as well get some interest on it. So instead of cash let’s say we generate risk-free returns on whatever percentage we pull out of our VFINX/VBLTX portfolio, from investing those assets in US treasuries for example. The next figure shows the expected returns vs. volatility curves for various allocations to a risk-free investment that returns 1.5% annually. (click to enlarge) To clarify, the highest curve the same as we saw before; the next highest is 10% receiving risk-free 1.5% annual returns, and the remaining 90% split to VFINX/VBLTX in 10% increments; and so on until the lowest curve (which you can barely see), which is 90% risk-free 1.5% annual returns, and the remaining 10% split to VFINX/VBLTX in 10% increments. The first curve to extend to a volatility of 0.298 is the one with 40% allocated to the risk-free investment. For this portfolio, we would have to allocate the remaining 60% of our assets to 30% VFINX/70% VBLTX, to achieve an expected return of 0.0226% with volatility of 0.298%. Now let’s consider option (2). The next figure is the same as the last one, but with the curves for VFINX/VBIIX and VFINX/VBISX included. (click to enlarge) Interestingly, swapping VBLTX for VBISX lets us reach a volatility of 0.298 with a mean daily return slightly higher than that reached with VFINX/VBLTX and 40% risk-free. A 24.7% VFINX/75.3% VBISX portfolio has means returns of 0.0232%. A natural question is how the risk-free rate affects whether strategy (1) or (2) is better. For the Vanguard funds examined here, strategy (1) would always outperform strategy (2) if the risk-free rate was 4% or higher (i.e. rarely or never). Strategy (2) would always outperform strategy (1) if the risk-free rate was 0% (i.e. you held cash rather than treasuries). For risk-free rates between 0% and 4%, it really depends on the particular level of volatility you’re trying to achieve. Conclusions I think a lot of investors operate under the assumption that increasing exposure to bonds reduces volatility. But in fact there is often a point where further increasing exposure to bonds increases volatility and reduces expected returns. You don’t want to go past that point. To reduce volatility further than your two-fund portfolio allows, you can either allocate some of your assets to a risk-free investment, say US treasuries, or you can switch to a shorter duration bond fund. I favor the second strategy, as it tends to allow for greater expected returns and seems logistically easier to implement. More generally, I think it is very important to know where your portfolio is at in terms of the expected returns vs. volatility curve. You should have a good idea of how any potential change in asset allocation or choice of funds affects your portfolio’s characteristics.

Increase Your Portfolio’s Return By Dropping International Funds

Summary International stocks have underperformed historically – performing even worse in the recent past. Multiple hypothetical portfolios demonstrate the poor returns of international stocks. Short periods of outperformance by international stocks do not make up for their overall performance. Will International Stocks Really Outperform? With emerging markets in the dumps and international funds trailing the returns of domestic funds, analysts everywhere are calling for investment in international stocks, claiming that the chronic underperformance is a sign that they are “due” to outperform. International stocks may very well outperform in the next few years. There is nobody who can know that for sure. I am here to present the facts, and the facts show that international stocks have not been delivering on the promise of outperformance given their higher risk. An investment portfolio built entirely from U.S. stocks can outperform international portfolios while avoiding the political and currency risks of other smaller countries. Hypothetical Portfolios For the sake of this hypothetical situation, let us assume that the owner of this portfolio will be investing in 100% equities and plans to maintain that portfolio for the next decade before moving into some safer bonds. The owner of this portfolio currently has $300,000 invested. Let us see how this portfolio would have performed from 2005 to 2015. First, a control sample: 100% U.S. equities for the entire investment period, invested in the broadest manner possible with the Vanguard Total Stock Market ETF (NYSEARCA: VTI ). In this case, the portfolio would be worth $654,240 at the end of the investment period. Not too shabby, the portfolio has more than doubled with an annualized rate of 8.12% ( Source ). Let’s say the investor wished to broadly diversify his equity portfolio with companies from around the world, putting the U.S. weighting at around 40% with the Vanguard Global Equity Fund (MUTF: VHGEX ). In this case, the portfolio would be worth $533,880 at the end of the investment period. The portfolio has increased at an annualized rate of 5.93%. The investor has missed out on $120,360 ( Source ). Perhaps the investor believed that emerging markets would be a good addition to his U.S. equities. Let’s say the investor allocated 20% to emerging markets with the Vanguard FTSE Emerging Markets ETF (NYSEARCA: VWO ) and 80% to Vanguard Total Stock Market ETF. In this case, the portfolio would be worth $625,080 at the end of the investment period. The portfolio has increased at an annualized rate of just over 7.542%. The investor has missed out on $29,160 ( Source ). Let me note that emerging markets are the only international option I would consider. Emerging markets have outperformed U.S. markets from time to time and their current weakness has much to do with the strong U.S. dollar and oil prices. However, emerging markets do not represent all international stocks and therefore I still stand by the statement that international stocks, as a whole, underperform – as seen by the performance of broad international funds such as VHGEX. In all hypothetical portfolios, the investor would have been better off simply investing in the United States market and would have even paid lower fees (and perhaps taxes as well) while doing so. The below table and graph illustrate the results of including international stocks in your portfolio. (click to enlarge) (Excel, using data from Vanguard.com) (click to enlarge) (Excel, using data from Vanguard.com) International Stocks have Underperformed Historically U.S. funds have beaten international funds the past five, 10, 15, 20 and 25 years. Over the past 25 years, large-cap U.S. funds have gained an average 691%, vs. 338% for international funds. The graph below illustrates the difference in performance. (Please note I am not in favor of investments in managed futures. Managed future data is subject to extreme survivorship bias and the results are thus skewed. Survivorship bias is the logical error of concentrating on the people or things that “survived.” inadvertently overlooking those that did not because of their lack of visibility.) (click to enlarge) (AutumnGold) Small Bursts of Outperformance by International Stocks Don’t Make Them a Good Investment Some will argue that there are periods of time when international stocks outperform. This is true. However, these periods of time are often small and they haven’t made up for the underperformance both historically and lately, assuming investors invest gradually over time. For long term investors, a long history of strong performance is needed before an investment can be made. The United States stock market has provided that performance for over a century now. The below chart shows the periods of outperformance for domestic and international equities for roughly the past 20 years. As you can see, in the mid-80s international stocks did very well and mildly outperformed in the mid-2000s. However, in all other years the U.S. stock market outperformed and overall U.S. stocks came out far ahead as mentioned earlier, assuming you didn’t throw all your money into international stocks in 1984. However, most people invest over time and if you had done that, you would have had higher returns with domestic stocks. (Bason Asset Management) For the past 15 years domestic stocks have pulled ahead of international stocks by a fairly wide margin. This is achieved even when the domestic market returns are relatively normal compared to historical averages. International stocks have simply underperformed consistently. You would be very hard pressed to find an international broad market fund that has beaten a U.S. broad fund from inception to date with reasonable fees, assuming the inception dates are relatively similar and that the funds didn’t start around 1984. The Vanguard International Explorer Fund is one exception I have found as it has performed very well since inception in 1996. Unfortunately, over the past 10 years it has returned less than 6% annually. Having a Portfolio of Pure U.S. Stocks Outperforms and Provides International Exposure Investing in U.S. stocks doesn’t mean you lose out on foreign growth potential. In fact, U.S. companies are very savvy and have the luxury of being able to choose which countries to do business in. There is no reason the U.S. equity market can’t benefit from the growth of other nations. Companies in the S&P 500 get 46.2% of their earnings from overseas . If you are looking for diversification to reduce the risk of a drastic drop in your portfolio value, international stocks won’t help you. The 2008 stock market crash showed that all equities fell drastically at the same time. Investing in one country or another made no difference. So do the smart thing: invest in domestic funds and enjoy the decent returns, as boring as they may be.