How To Correctly Parse ETF vs. CEF Performance Results

Through the second half of 2021 we continued to see the usual pitch for CEFs that compares their performance against open-end funds like ETFs or mutual funds. We often see commentators flogging the same chart from BlackRock which is shown below. The chart shows the 10-year performance of various CEF sectors vs. their mutual fund counterparts for the period of 2012 to 2021.

BlackRock
BlackRock

There are a couple of problems with this.

First, it doesn’t account for the huge tailwind in lower yields with the yield of the high-yield corporate bond sector falling by a huge 4% from around 8.4% to around 4.5%. Higher-quality fixed-income sectors also received a significant boost as longer-term Treasury yields also fell over this period.

Second, leverage costs over this 10 year period were at rock-bottom levels for about half the time because the Fed kept its policy rate near zero.

Needless to say this was a very unusual market environment so presenting this as something investors should expect going forward is misleading.

Investors who allocated to CEFs wholesale on this basis were probably unpleasantly surprised. This is how the total price returns of the more popular sectors looks like since the start of the year relative to sector benchmark ETFs.

Systematic Income
Systematic Income

Most CEF sectors saw significant underperformance of their sector ETFs over this period, largely driven by discount widening.

Total NAV CEF returns have held up better and some have even outperformed their ETF counterparts.

Systematic Income
Systematic Income

To avoid these obvious biases we can compare returns over a more sensible period. A good date is 21-Dec-16 which had high-yield corporate bond yields, risk-free rates and credit spreads at roughly similar levels to today. Leverage costs are also more representative over this period rather than over the last 10 years because short-term rates started to rise in 2016 and capped out in 2019 not far from where they are expected to peak this hiking cycle as well.

This specific date is less relevant for equity sectors included in the chart but it is nonetheless interesting to note that CEFs in those sectors have not outperformed ETFs over this period. Unfortunately, this is a common theme we find across different time periods though you won’t hear about it from strong proponents of equity CEFs.

Systematic Income
Systematic Income

The upshot here is that the annual High-Yield CEF sector outperformance falls from 2.2% per annum to 1.1% per annum, the Loan CEF sector outperformance falls from 2.1% per annum to 1.1% per annum and the Municipal sector outperformance falls from 2.7% per annum to 0.8% per annum.

There are two pieces of good news. First, this more sensible period of analysis shows that credit CEF sectors do appear to outperform their open-end fund counterparts in aggregate. This is not at all surprising given CEFs tend to carry embedded leverage and, hence, give investors exposure to a greater amount of assets per $1 of invested capital.

The second piece of good news is that the current CEF market offers a much more attractive time to invest than most of last year. This situation obviously improves the yields on offer as well as forward returns for investors who have the capital to allocate to the sector now than if they were fully invested last year.

The takeaway here is that investors have to be aware that outperformance requires a decent entry point. This may feel like “trading” or “timing” the market but it’s just value-based investing applied to CEFs.

Thanks for reading.


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