Income investors are always on the lookout for “quality” funds and there is no dearth of commentary extolling the virtues of various supposedly quality CEFs. In this article we try to pin down the characteristics that make a “quality” CEF. More specifically, we settle on two key features. The first is historic outperformance in absolute and/or relative terms of the fund’s sector and passive open-end alternatives. And the second is a set of good governance features such as discount control, reasonable management fees and avoiding the pitfalls of overdistributing. This is far from a complete list and most funds have features that point in different directions. Ultimately, the fund characteristics that underpin these features put shareholder interest first and deliver outperformance.
What Is Quality?
“Quality” probably has as many definitions as there are investors. In our experience, quality is usually discussed in either absolute or relative terms. An absolute definition of quality has to do with the fund’s holdings, so a fund that holds agencies, Treasuries, investment-grade credit or munis is typically viewed as a high-quality fund. A relative definition of quality has to do more with the fund’s approach to managing its assets. So, a high-yield fund may be low quality from an absolute, portfolio holdings perspective, but if it generates returns over its benchmark without taking undue risk or charging excessive fees and, in general, tries to do well by its shareholders then it can be viewed as a high-quality within its area of focus.
What this dichotomy suggests is that a fund can fall anywhere on the 2×2 absolute / relative quality matrix. A fund with high-quality holdings can be low or high quality with respect to how it manages those holdings and the same with a fund with lower-quality holdings.
In this article our focus is more on the fund’s management approach within its area of operation, rather than in terms of portfolio holdings as the quality of portfolio holdings are probably less contentious and more transparent to individual investors.
It’s important to say that first, not everyone will agree on the quality criteria that we propose here. Some investors will value one set of criteria more than others given their different utility functions and investment views. And secondly, our proposed list is not all-or-nothing. In other words, funds can fail on some quality criteria while making up for them in other areas. For example, funds that charge high fees may be able to make up for this additional fee drag through a strong alpha-generation profile. Let us know what other quality characteristics of CEFs you value in the comments.
Relative Performance
The importance of performance and historic returns is not universally valued – some investors, for instance, place a greater focus on income or, what they really mean by income, distributions. The trouble with a focus on distributions as a quality metric above that of performance is that distributions can be just about anything a fund wants them to be.
The reason why performance or historic returns are important is two-fold. First, there is no getting around the fact that decent returns are absolutely essential for sustainable distributions. A fund that is not able to sustainably generate the returns behind its distributions will eventually see its assets move substantially lower in the absence of, what are likely to be, dilutive rights offerings.
The second reason why historic performance is important is because they provide some insight into the skill of the managers to whom investors entrust their hard-earned capital. After all, investors nearly always have a number of investment options in a given sector so a look at longer-dated historic returns is a valuable thing. The longer the historic track record of a given manager the less impact luck has on their performance against their competitors.
Investors are occasionally dismissive of “total returns” but this often confuses two different things: performance of a given fund within its sector and a “total return” investment approach which is usually synonymous with a pro-growth, high-beta style. However, the two are very distinct. Ultimately, the total return of a given fund is essential in growing the wealth of an income portfolio from which all income ultimately derives and it provides a clue to a fund manager’s skill in navigating a given sector for which he can claim to deserve investor capital.
So, how should we look at historic returns? In our view, we first need to look at NAV returns over price returns. This is because NAV returns are the only thing that CEF managers have control over – price returns, particularly over the short and medium-term, are a function of moves in discounts.
And secondly, we should look at CEF returns both relative to passive ETF benchmarks that allocate to the same sector and we should also compare the CEF to other CEFs in the same sector. It should be said that it can sometimes be difficult to find the right ETF benchmark for a given CEF as CEF holdings often range across several different sectors.
To see how this can work in practice, let’s take a look at the popular Reaves Utility Income Fund (UTG). The chart below shows total NAV returns of utility sector CEFs alongside the ETF Utilities Select Sector SPDR Fund (XLU).
If we look over various reasonably long time-frames we can see that the fund has done ok within the CEF sector itself – it has the top 7-year and 10-year total NAV returns and the second-highest 5-year total NAV return.
However, curiously, it (as well as every other sector fund) lags behind XLU across every time frame.
This is really strange since UTG uses leverage while XLU does not and stocks, broadly speaking, are way up over the last 10 years – 11-14% annualized depending on whether you’re looking at utilities or the S&P 500. Just purely mechanically, if you lever up asset X and X rallies strongly you should be able to handily outperform X.
This means that our UTG vs XLU comparison is not actually apples to oranges and so is not fair – to XLU. Let’s see what happens if we instead compare UTG NAV performance to a “fund” we’ll call LEV XLU that leverages XLU 25% and pays LIBOR+0.80% on the leverage which is what UTG pays. What we see is huge outperformance of UTG by nearly 2% per annum.
There are a few possible responses to this. First is – well XLU is not a fair benchmark to use since UTG allocates outside of utilities into telecoms, media, REITs etc. Its utility exposure is only about 2/3 of the fund. This is a reasonable comment, however, the problem with it is that 1) the fund calls itself a utility fund and 2) its own benchmarks in the shareholder report are the S&P 500 Utilities Index and the Down Jones Utility Average – both very much utility sectors.
Another possible response to this is that, well, NAV is what it is but price is what really drives your portfolio returns. This is true on its face but, recall, that the reason we want to look at NAV is to gauge whether or not the fund managers are adding any value and the only way we can gauge this is by looking at the NAV. But in any case, as it happens, the fund’s price returns do not actually change the analysis.
Another possible response here is that, well, yes the last 10 years have been ho-hum for UTG but the fund really killed it prior to that. This is true – if we extend the our observation window to the period right after the financial crisis, the fund hugely outperformed XLU in 2009 and 2010, by around 25% per annum over those two years.
However, the trouble with this is that the fund hasn’t really been able to replicate that outperformance over the past decade and, more likely than not, most current fund shareholders were not also shareholders during those years to enjoy that outperformance. The irony here is that the fund’s current shareholders may, in some part, be holding the fund because of its historic outperformance in 2009-2010 but did not actually enjoy those stronger returns.
The second reason why the lack of outperformance in UTG may seem odd is that active management doesn’t appear to have helped the fund outperform despite what has been a fairly volatile decade which, presumably, should have delivered a number of fat pitches. Now, it has to be said, this is not surprising. In fact, the entire utilities CEF sector has struggled to outperform a simple passive sector ETF. In addition, decades of research into active vs. passive management shows that actively managed funds really struggle to outperform their passive counterparts, at least over the longer term. This is not to excuse the performance of UTG but it’s also not entirely surprising.
Finally, it’s worth saying that while UTG has not delivered any outperformance, its volatility and historic drawdowns have been much greater than that of XLU resulting in a not-so-great combination of sub-par returns and higher volatility. This is important because CEF drawdowns have multiple negative knock-on impacts. They reduce investor capital just when it’s most needed to potentially reallocate into more attractive opportunities. Secondly, they exacerbate negative behavioral tendencies that makes it difficult to remain invested. Thirdly, they increase the likelihood of CEF deleveraging and locking in of permanent capital loss. So, in short, a fund that delivers broadly the same return with much higher volatility and drawdowns is not ideal.
So, what does this mean for UTG, in particular. Given its disappointing historic performance relative to a simple passive benchmark despite much higher portfolio volatility and drawdowns, it’s very difficult to call UTG a “quality” fund. Yes, the fund has strong returns with respect to other utility CEFs, but it underperforms a simple passive ETF over various timeframes of up to 10 years. And whatever outperformance the fund does boast happened more than a decade earlier. This might be fine had the fund boasted lower volatility and drawdowns – in which case it would have higher risk-adjusted returns but this is not the case.
Governance Characteristics
Unlike historic returns, governance issues are multi-faceted. The one thing they have in common is that they should aim to do well by the shareholders.
The first to discuss are management fees. In general, CEF fees are levied on total managed assets which has become a common practice. This has a number of problems, however – it not only results in hefty fees on net assets – the number that actually matters to investors, it also incentives funds to run at an elevated leverage level which may not necessarily be in the investor’s interest given the higher likelihood of deleveraging. To illustrate the impact, consider two CEFs both at 30% leverage with one charging 0.6% on total assets and the other the same on net assets. The 0.6% fee on total assets works out to a fee of 0.9% on net assets or 50% higher than the fee of the second fund. Plus, from a purely operational perspective, a fund that runs at a 30% leverage versus no leverage surely does not require a 50% higher effort in managing it.
There are some funds that charge management fees on net assets but they are in the minority. Alliance Bernstein and MFS appear to be two fund managers that consistently charge fees on net assets at a level that is comparable to fees charged by other managers on total assets. For example, the MFS High Yield Municipal Trust (CMU) charges 0.65% on net assets which works out to be about 0.10-0.20% below the level of other municipal CEFs like BlackRock and Nuveen that tend to charge 0.5-0.6% on total assets with leverage levels of around 30-35%.
Some funds charge weirdly high fees such as the Angel Oak pair of bank debt CEFs: Financial Strategies Income Term Trust (FINS) and Dynamic Financial Strategies Income Term Trust (DYFN) whose 1.35% fee on total assets ends up sucking up nearly half of the resulting net investment income that flows to investors. Such a high level of management fees is not only obviously high but it also means that the fair-value discount of these funds should be well into double digits, likely disappointing investors who pick up these funds in search of a bargain.
Some investors don’t care a whole lot about management fees since its impact is, in effect, hidden from them, particularly when funds overdistribute. It’s a bit like a withholding tax that that individual investors never have to reach into their pocket to pay. Our view, however, is that investors should care about management fees. And this is because for two funds with different fees to earn the same amount the fund with the higher fee has to either run at a higher leverage, allocate to riskier assets or generate a higher level of trading alpha.
Another important indicator of good governance is what the fund does about discount control. Not all funds have this problem – funds with strong brand identity like PIMCO boast funds that trade at premiums due to their strong historic returns and high distribution rates. Other funds don’t enjoy this privilege, however. A fund that employs discount control measures recognizes that its total price return is important to shareholders and under its control, to some extent. It also puts shareholder interest ahead of its own by being willing to lower its portfolio assets to benefit shareholders.
There are a number of things a CEF can do to control its discount. Some funds schedule future shareholder votes to convert to an open-end fund such as the RiverNorth/DoubleLine Strategic Opportunity Fund (OPP) which plans to hold a vote in 2021 on whether to convert to an open-end fund.
Other funds hold tender offers, often, it has to be said, under pressure from activist investors. The Western Asset Global High Income Fund (EHI) recently went through what was a very successful tender offer for participants, driving 4% of pure alpha (and 2% of additional NAV boost) over a span of just a couple of weeks. A fund that is currently on our radar is the Voya Prime Rate Trust (PPR) though its tender offer features are not as attractive as those of EHI. A few funds provide periodic buybacks akin to interval funds such as the BlackRock Enhanced Government Fund (EGF) or the RiverNorth Specialty Finance Corporation (RSF).
Term CEFs provide a measure of discount control as their discounts are expected to move to zero on termination date. They also tend to have smaller historic price drawdowns versus their sectors, likely as a result of this discount anchoring. A fund we continue to like here is the Nuveen Preferred & Income Term Fund (JPI) which has a termination date in 2024 but is trading at a discount wider of the sector average which provides a potential tailwind into termination.
Repurchase programs are quite common across CEFs and can provide some discount support. These programs give fund managers discretion to buy back shares of their fund when the discount is particularly wide. This not only supports fund prices but is also accretive to fund total returns. For example, the Wells Fargo Income Opportunities Fund (EAD) has added 0.5-1% per annum to its NAV over the previous couple of years through its buyback program.
To check the broad impact of these programs the chart below plots the median discount of CEFs with a repurchase program and without in the nationoal municipal sector. It’s interesting to see that funds with a repurchase program traded at a wider discount prior to the drawdown but had a smaller discount widening in March and are currently trading at a tighter discount to funds without a repurchase program. This could be due to the fact some some funds instituted the repurchase program only this year.
Another key fund governance feature is overdistributing relative to the fund’s income. Making distributions from, say, capital gains in and of itself is not terrible (though it does raise the question of whether CEF fund managers are best placed to create capital gains tax events for individual investors) and it is the hallmark of many equity CEFs which most investors are just fine with. The mere fact of distributing capital gains (and by this we mean beyond the regulatory RIC requirement of distributing realized capital gains but, specifically, planning to distribute capital gains each year) is not in itself a sign of bad governance.
However, regularly over-distributing relative to fund income can create additional potential issues for funds which can result in poor governance behavior. First, is what happens when capital gains are not there to turn into distributions. In this case, the funds will have to turn to distributing ROC if they want to maintain their distributions. Whether ROC distributions are bad is a divisive issue and we don’t litigate it here. Suffice it to say that consistent ROC distributions will tend to decrease the fund’s assets which will incentivize managers to raise assets through (typically NAV dilutive) rights offerings. These are dilutive not in the sense that shareholders hold a smaller percentage of the fund, which is not something anyone should care about, but in the sense of being anti-accretive – that the rights offering typically lowers the value of each share.
Of course, this is not a complete list of what qualifies as good or bad governance. It’s also worth saying that some funds have governance features that point in different directions. For example, RiverNorth funds have their good-governance contingent conversion feature to an open-end fund but also feature bad-governance repeated rights offerings due to their tendency to over-distribute.
Takeaways
Though different investors will have different ideas of what “quality” means with respect to a CEF, they will agree that a quality CEF is one that tries and succeeds in delivering value for shareholders through different mechanisms at its disposal such as returns, fees, discount control and other factors. Though it can be tricky to gauge quality in the CEF space, our view is that investors will ultimately be rewarded by tilting to quality funds across the dimensions relevant to their investment process over the longer-term.
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