The CEF market can often upend expectations of different types of investors – for more tactical investors who closely follow the daily gyrations of discount valuations as well as for low-turnover investors who only make occasional tweaks to their portfolios and simply want to hold a “solid” fund in a given sector.
The key issue is that certain fund features or risk tilts can make a significant difference to fund NAV returns which can swamp valuation considerations or cause apparently “solid” funds to significantly underperform.
As an example let’s take a look at the year-to-date total NAV returns in the preferreds CEF sector shown below. One would think that returns would be more-or-less the same for funds that allocate to the same sector, however the range for YTD NAV returns is nearly 10% – from 6% to almost 16%. And this is all in the context of credit markets which have not moved a whole lot since the start of the year – high-yield corporate bond yields have moved just 0.30% over the last 9 months.
Source: Systematic Income
For illustrative purposes we divide the chart into three areas – orange for the majority of funds in the sweet spot of returns of about 8-9%, underperforming funds with returns below 7.5% and outperforming funds with returns around 10% and above.
In our view, the following allocation stances across the sector drove the performance dispersion this year. We can’t prove this is actually the case but it makes sense to us.
- John Hancock Premium Dividend Fund (NYSE:PDT) was the biggest outperformer by virtue of having an unusually large allocation to common stocks of 40% in an environment of a strongly rising stock market as well as a fairly cyclical sector stance. We would argue that PDT does not actually belong in the Preferreds sector but should instead be in the Hybrids sector. In other words, investors who think they are getting preferreds exposure in a “best-of-breed” preferreds CEF are close to half in common stocks instead.
- The trio of John Hancock funds (John Hancock Preferred Income Fund (NYSE:HPI), John Hancock Preferred Income Fund III (NYSE:HPS), John Hancock Preferred Income Fund II (NYSE:HPF)) have only delivered marginal outperformance of the middle-group. This is likely due to their slightly lower credit-quality stance, a lower allocation to financials – a sector which held in very well through 2020 and, hence, did not offer particularly high carry at the start of 2020, a much larger allocation to utilities and a slightly larger allocation to more cyclical sectors like energy and REITs, as well as a lighter interest-rate hedging footprint that had a lower drag on income that the Nuveen and Cohen & Steers funds.
- Nuveen Preferred and Income 2022 Term Fund (NYSE:JPT) was an underperformer primarily due to its low leverage in the sector at around 20% versus a 30-33% range for the other funds. This has to do with the fund’s term structure and a fairly near scheduled termination date in 2022.
- Nuveen Preferred & Income Securities Fund (NYSE:JPS) was an underperformer, in our view, due to its unusually high-quality allocation in the sector with a 30% higher allocation to investment-grade securities.
Source: Systematic Income CEF Tool
- The Cohen & Steers funds (Cohen & Steers Select Preferred and Income Fund (NYSE:PSF), Cohen & Steers Limited Duration Preferred & Income Fund (NYSE:LDP), Cohen & Steers Tax-Advantaged Preferred Securities & Income Fund (NYSE:PTA)) have relatively high allocations to financials and have larger interest-rate hedges which has not allowed them to benefit from the drop in short-term rates on their credit facilities, causing a larger drag on income than was the case for most other funds in the sector
To sum up – the key fund features or allocation tilts to keep in mind for investors are leverage levels, interest rate hedges, sector allocation, credit-quality profile and asset class tilts.
There are three key points here. The first is that investors should understand not only what individual allocation profile or risk tilts a given fund has but also how it compares to the rest of the sector. By selecting an individual CEF an investor is implicitly adopting the allocation choices and risk tilts of the fund, whether they are aware of it or not. And because different funds make different choices, there is no single “best” fund that will perform best in all market environments. This doesn’t mean investors have to chase every move in markets by tweaking their portfolios but it does mean that each fund allocation carries with it an implicit market stance.
This leads to the second point which is that it is a rare CEF that can outperform in all market environments. This means that a “solid” choice in any given sector is a largely meaningless concept. Individual CEFs have outperformed historically for, typically, contingent reasons such as they were overweight duration in a falling rate regime or they were overweight lower quality holdings in a supportive macro environment or they held assets that had a one-off revaluation which is not to be repeated such as bank preferreds or legacy non-agency RMBS after the GFC. Investors should try to look through to the fund’s key differentiating factors to guide their allocations.
A third point is that we don’t want to imply that investors who held underperforming funds made the wrong decision and investors who held the outperforming funds made the right decision. The issue isn’t what funds investors held but the reasons why they held those funds. Specifically, investors who held JPT because, as a term CEF, it offered a measure of discount control and lower drawdown potential – the decision to hold it was entirely sound. And investors who held PDT because they were attracted by its high distribution rate (despite its poor coverage) in the sector simply lucked out because stocks had a huge run-up.
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