CEF investors who like to read market commentary or who want to do additional due diligence on potential allocations have a lot of analysis at their disposal. However, as with anything, it is important to avoid some of the hazards that can do more harm than good.
One such common hazard is what we call the “snowflake theory of CEF investing” where CEFs are discussed individually, without reference to other potential choices or the broader sector. The reality is that CEFs exist in a competitive ecology with similar constraints, strategies and tools. The case is even stronger across funds of a given issuer. For example, the chart below shows the NAV return correlation matrix of the preferreds CEF sector with red highlighting very similar funds and green relatively dissimilar funds.
Few investors who follow the space will be surprised that the highlighted Flaherty suite of 5 funds are incredibly similar. This means that discussing one fund in the suite, without providing context for the broader suite doesn’t make a ton of sense. The question that investors ought to ask is – why this fund over the rest in the suite or the broader sector?
Another hazard for investors to watch out for is “rear-view mirror analysis” – for example, discussing fund coverage metrics without providing context for how fund income has changed since the last shareholder report. The problem is that shareholder reports are only provided semi-annually and even then with a significant delay. Many funds publish borrowings information on a monthly basis which will signal whether they have increased or decreased their income-generating asset base. Fund leverage cost is also linked to short-term rates which, until recently, were relatively volatile, delivered regular headwinds or tailwinds to fund income levels and will do so again once short-term rates move off their zero bound.
A final hazard we’ll touch on here (though it’s far from a complete list) is what we call “stuff I made up“. These are comments or views that stem from a misunderstanding of market mechanics. One such comment is that rising Fed policy rates typically boost the incomes of fixed-income funds. This is obviously wrong as short-term rates either have no impact on the fixed coupon securities typically held by these funds (hence the term fixed-income) or they actually decrease fund income levels through a rise in leverage cost as leverage instruments are usually tied to short-term rates such as Libor which are tightly linked to the Fed policy rate.
Keeping an eye on these three hazards is likely to result in a smoother and more enjoyable journey for CEF investors.
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