Is Leverage Really An Advantage In Equity Closed-End Funds?
Prevailing wisdom holds that bullish market conditions favor leveraged, equity closed-end funds. Similarly, declining or flat markets are seen as favoring the unleveraged, option-income equity closed end funds. I look at comparable funds of each type for the period 2006 through 2015YTD to see how well this premise holds up. Closed-end funds (or CEFs) are primarily about income, less so about beating the market. If I may generalize, it’s the rare equity closed-end fund that beats, or even matches, other investment vehicles in its individual arena over sustained periods of time; but nearly all of them provide high levels of distribution income to their investors. If you’re not interested in the high yield, for domestic equity, you’re almost always going to be ahead of the game in either individual holdings, wisely chosen, or a solid indexed ETF. Of course there are exceptions; every generalization has exceptions, and I welcome your examples if you want to share them (with evidence if you please). But, by and large, I think this view holds up to careful scrutiny. Of course, some have success trading funds as their discounts and premiums fluctuate, or rack up gains in odd arbitrage situations that occasionally come up for CEFs, but that’s more specialized than what I have in mind. For the purposes of this article, I’m considering equity CEFs held primarily for current income and capital appreciation. For equity CEFs, there are two paths to generating that high income with capital appreciation. First is by exploiting the power of leverage to drive gains, and second is by an aggressive use of option trading, especially covered calls. Each strategy has its upsides and downsides. The conventional wisdom is that option funds are more defensive and do better in down or sideways markets. By this view, leveraged equity funds are at their best in strongly bullish markets. Makes sense, but the subject has come up several times in comment streams and private messages questioning those assertions when I’ve repeated them. I’ve been looking for evidence to support (or negate) that particular set of generalizations. I’m sure such research exists, but I’ve not put my hands on it so I thought I’d take a quick look. What I’ll report on here is not a rigorous analysis. It has a limited number of data points, covers a brief period, and is hardly more than observational in the large scheme of things. But it is what I’ve been able to put it together without an excessive investment of time given the limited sets of data I have access to. I would encourage anyone so inclined to make a more detailed analysis. For the present, I think CEF investors will find even a cursory analysis interesting enough to generate discussion. I decided to look at CEFs from a single sponsor. I selected 6 Eaton Vance equity closed-end funds, 3 each leveraged and unleveraged. I picked Eaton Vance because I think a good case can be made that theirs are among the best-managed equity CEFs. That, plus I own several, so it was of interest to me on a personal portfolio level as well. Funds were chosen on the basis of having the best 3 yr returns on NAV, an arbitrary cut, but straightforward data to obtain for large numbers of funds – NAV returns for longer time periods is not readily available in formats that can be used as to filter the data. I compared total return (market) for each by calendar year using data from YCharts for each of the funds. The six funds and current values for effective leverage are: Effective Leverage EV Enhanced Equity Income II (NYSE: EOS ) 0.00% EV Tax-Managed Div Equity Inc (NYSE: ETY ) 0.00% EV Tax-Managed Buy-Write Opps (NYSE: ETV ) 0.00% EV Tax Advantaged Dividend Inc (NYSE: EVT ) 21.05% EV Tax Adv Global Dividend Inc (NYSE: ETG ) 23.25% EV Tax Adv Global Div Opps (NYSE: ETO ) 24.38% The earliest year with complete data for all 6 funds is 2007. The period from 2007 through 2015 YTD covers the deep downturn of the recession and the strong bull market of the past few years, so there is a complete and extreme cycle. Plotting the average, maximum and minimum returns from the three funds of each class produces these charts. It’s clear that the leveraged funds fared much more poorly in the 2008 bear market than did the unleveraged funds. But it is difficult to see a clear pattern over the other years. To bring some clarity, I calculated the excess return of leveraged funds vs. unleveraged funds for each year, and plotted those values against annual returns of the S&P500 index. (click to enlarge) In this plot the Y axis represents the level of relative performance by leveraged funds and unleveraged funds. Outperformance by leveraged funds is represented by the area above the 0 line. Differences between funds in the two categories are shown here in basis points, so these data include highly meaningful differences in return to an investor. The trend line is consistent with the predicted relationship: For down years the option-income funds outperform. The correlation is weak at best, however: r 2 for the relationship is only 0.188. The trend line we see in this chart is strongly influenced by the 2008 data where, as we have already seen, the unleveraged funds strongly outperformed (in the sense of being much less negative) the leveraged funds. What happens if we look at the chart with that heavy weight of 2008 omitted? A different picture, but not one that adds clarity, emerges. (click to enlarge) What we see here is a weak trend in the opposite direction. The trend is even weaker than when 2008 is included (r2 = -0.069). Unleveraged funds outperformed the leveraged funds during the two years of highest returns for the S&P 500 (2009, 2013). This result cuts against that predicted from conventional wisdom. The leveraged funds did, however, outperform in years with moderately high returns, but from the full set of results that can as easily be attributed to chance as any advantage derived from market conditions that those funds may have had. The best we can say here is that any outperformance by leveraged funds is essentially uncorrelated to broader market performance. So, how fares the prevailing dogma on the topic? There’s a bit here to support it, in the sense that for the disastrous 2008, leveraged funds suffered much deeper losses than the unleveraged funds. But beyond that extreme case, which is after all only a single data point, there is little to support (or negate) the prevailing view that strongly up markets favor the leveraged funds. Clearly, this is only a glimpse at the full situation but, to my mind, there is sufficient information here to call into question idea that there are advantages for leverage funds in relation to prevailing market up trends. Which leads to the question: If leveraged funds cannot consistently outperform in bullish markets, why invest in them at all? I think an evaluation of the advantages or disadvantages of investing in leveraged equity is particularly relevant to the current situation where rising interest rates will increase leverage costs, however modestly, thereby increasing the drag on those funds. I have been avoiding leveraged equity CEFs for some time, in part because of the widely held view that less bullish markets favor the option-income funds, and in part because of previous research ( Debunking the Myth of Leverage for Closed-End Funds ), which did not consider overall market conditions, that showed little advantage to leverage in closed-end funds of various categories. As readers know, I am a fan of CEFs for providing income with capital preservation — as bond substitutes if you will. It’s been my view, which this brief look at the issue supports, that option-income is a more effective strategy for accomplishing those objectives than simply throwing leverage at it. So, for those looking for an explicit conclusion: Leverage is unlikely to provide returns that justify its inherent risk, even under conditions that are assumed to favor leveraged investing.