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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.

PHB: This Junk Bond Goes Better With REITs Than With The S&P 500

Summary PHB is a junk bond with an emphasis on the 1 to 10 year range. The sector allocation looks pretty good but investors should avoid buying both junk bonds and equity in the consumer discretionary sector. Due to correlation with major indexes, the junk bond ETFs show better correlation benefits with equity REIT funds than with the S&P 500. Investors going heavy on domestic non-REIT equity positions should use longer term treasury securities rather than junk bonds. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve the risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. I’m working on building a new portfolio and I’m going to be analyzing several of the ETFs that I am considering for my personal portfolio. One of the funds that I’m considering is the PowerShares Fundamental High Yield Corporate Bond Portfolio ETF (NYSEARCA: PHB ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. Expense Ratio The expense ratio is .50%, which is high for a bond fund. That should be a material concern to investors. With yields being relatively low by historic measurements, high expense ratios can quickly create a drag on returns. Credit The credit rating allocations are about what you might expect for a “high yield” bond ETF. Simply put, most of the holdings should be junk bonds and they are. I appreciate that Invesco, the fund sponsor, includes the rating data from both S&P and Moody’s. Maturity The maturity range feels fairly standard for a junk bond ETF. No allocation to bonds longer than 10 years and a heavy focus on the 5 to 10 year range. I’d like to see a yield a little higher than 4.51% for investing in the ETF. The exposure to the 5-10 year range feels a little bit heavy for the yield. I would have expected a heavier portion of the portfolio to be in the 1 to 5 year range. Sector When it comes to the sector allocations, I can’t help but appreciate the way PHB did this. The portfolio structure is extremely diversified when it comes to sectors. The one area that is very notably overweight is the consumer discretionary sector. Because that sector is heavily weighted in the junk bond portfolio, I wouldn’t want to be using an allocation to any ETF that was specifically focused on the consumer discretionary sector. Junk bonds, by definition, are bonds with credit concerns. I wouldn’t want to risk being screwed on equity prices while seeing the bond holdings drop in value because of bankruptcies in the sector. As long as this fund is not combined with a position in the consumer discretionary segment or the energy segment, the fund looks like a nice fit for slipping into a portfolio to increase the yield. The goal here is to improve the income from the portfolio so that investors can live off the income without having to sell off any of the principal. Building the Portfolio The sample portfolio I ran for this assessment is one that came out feeling a bit awkward. I’ve had some requests to include biotechnology ETFs and I decided it would be wise to also include a the related field of health care for a comparison. Since I wanted to create quite a bit of diversification, I put in 9 ETFs plus the S&P 500. The resulting portfolio is one that I think turned out to be too risky for most investors and certainly too risky for older investors. Despite that weakness, I opted to go with highlighting these ETFs in this manner because I think it is useful to show investors what it looks like when the allocations result in a suboptimal allocation. The weightings for each ETF in the portfolio are a simple 10% which results in 20% of the portfolio going to the combined Health Care and Biotechnology sectors. Outside of that we have one spot each for REITs, high yield bonds, TIPS, emerging market consumer staples, domestic consumer staples, foreign large capitalization firms, and long term bonds. The first thing I want to point out about these allocations are that for any older investor, running only 30% in bonds with 10% of that being high yield bonds is putting yourself in a fairly dangerous position. I will be highlighting the individual ETFs, but I would not endorse this portfolio as a whole. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield SPDR S&P 500 Trust ETF SPY 10.00% 2.11% Health Care Select Sect SPDR ETF XLV 10.00% 1.40% SPDR Biotech ETF XBI 10.00% 1.54% iShares U.S. Real Estate ETF IYR 10.00% 3.83% PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB 10.00% 4.51% FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT 10.00% 0.16% EGShares Emerging Markets Consumer ETF ECON 10.00% 1.34% Fidelity MSCI Consumer Staples Index ETF FSTA 10.00% 2.99% iShares MSCI EAFE ETF EFA 10.00% 2.89% Vanguard Long-Term Bond ETF BLV 10.00% 4.02% Portfolio 100.00% 2.48% The next chart shows the annualized volatility and beta of the portfolio since October of 2013. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. You can see immediately since this is a simple “equal weight” portfolio that XBI is by far the most risky ETF from the perspective of what it does to the portfolio’s volatility. You can also see that BLV has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in TDTT is also unique for having a risk contribution of almost nothing. Unfortunately, it also provides a weak yield and weak return with little opportunity for that to change unless yields on TIPS improve substantially. If that happened, it would create a significant loss before the position would start generating meaningful levels of income. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Name Ticker Role in Portfolio SPDR S&P 500 Trust ETF SPY Core of Portfolio Health Care Select Sect SPDR ETF XLV Hedge Risk of Higher Costs SPDR Biotech ETF XBI Increase Expected Return iShares U.S. Real Estate ETF IYR Diversify Domestic Risk PowerShares Fundamental High Yield Corporate Bond Portfolio ETF PHB Strong Yields on Bond Investments FlexShares iBoxx 3-Year Target Duration TIPS Index ETF TDTT Very Low Volatility EGShares Emerging Markets Consumer ETF ECON Enhance Foreign Exposure Fidelity MSCI Consumer Staples Index ETF FSTA Reduce Portfolio Risk iShares MSCI EAFE ETF EFA Enhance Foreign Exposure Vanguard Long-Term Bond ETF BLV Negative Correlation, Strong Yield Correlation The chart below shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion This is a solid fund in most aspects. I’d like to see a slightly higher yield for the level of duration risk but that isn’t too bad. The expense ratio could use some work, but it still has some merit in a portfolio. The most interesting thing for investors is that the fund has a fairly high correlation with the S&P 500. When investors are using modern portfolio theory, they may notice that bonds typically have a higher correlation with REITs than with the S&P 500. In this portfolio the REIT exposure is coming from IYR. PHB has a correlation of only .39 with the REITs while posting .60 with the S&P 500, so that should be an interesting factor for investors. Essentially this is suggesting that this kind of junk bond fund makes more sense beside equity REITs than it does with the S&P 500. In short, if investors are using equity REITs as a major source of income, they may want to consider diversifying that position to include one in junk bonds due to the lower correlation of the two investments. Since both investments produce a material amount of current income that is an appealing factor for the dividend growth investor that needs a little more yield. On the other hand, investors that are going very heavy on domestic equity (excluding REITs) would be better served by long term treasury ETFs because the correlation between junk bonds and the S&P 500 is a little too high.