What You Should Expect From A High Yield Closed-End Fund
Mar. 16, 2015 11:44 AM
- CEFs are odd beasts in the investing world.
- They trade like stocks, but act like mutual funds.
- So what should you expect when you buy one?
Closed-end funds are the El Camino of the investing world. For those that don't know what an El Camino is, I'm sure you've seen one-it's a half sedan/half pickup truck thing. It sticks out because it's odd looking. Closed-end funds, or CEFs, are very similar, being traded like stocks with a set number of shares, but operated like a pooled investment vehicle. And because of this odd makeup, investors need to clearly understand what they can expect from these industry oddballs.
Is that all there is?
One of the areas in which CEFs stand out is income, with many CEF's providing yields in the high single digits or even low double digits. Open ended mutual funds rarely offer such yields. There are a number of reasons for this, including the use of options in CEFs to generate income, the ability to use leverage, and the frequent policy of managing distributions at either a set dollar amount or set amount of assets.
For example, Blackrock Health Sciences Trust (NYSE:BME ), a closed-end fund I own, makes use of options to generate income. It also has a set monthly dividend that it pays. Gabelli Equity Trust (NYSE:GAB ) pays out 10% of its net asset value every year. Adams Express (NYSE:ADX ), meanwhile, sets its distribution target at 6% of net asset value every year.
This is important because it can have a material impact on the share price of CEFs. The topic came up in a comment on a recent article I wrote. the reader basically asked, "Is the distribution all you should expect from a closed-end fund?" And the answer depends greatly on the distribution policy.
Too much of a good thing
Using a rule of thumb, you'd expect the market to produce returns of around 10% over the long term. Not every year, but on average over time. But how does that play with the Gabelli model of distributions? Let's assume there is a fund with 10 shares and net assets of $100. Each share has a net asset value of $10. Easy math, but I like simple things.
If during a year the fund earned the market return of 10%, it's net assets would go up to $110. Each of the 10 shares would then be worth $11. But like Gabelli Equity Trust my pretend CEF pays out 10% of its net assets every year. In this case that would be $11. So every share gets $1.10 in dividends. At the end of the year the fund's net assets would be $99. So every share would be worth $9.90.
Since distributions are part of total return, your return for the year would be 10%. But the NAV of the
fund would have fallen slightly. Our imaginary fund would actually have to perform better than the market over time to maintain its NAV. The Adams Express model of a 6% target would, clearly, provide more wiggle room for growing the NAV. And I didn't factor in expenses, which would reduce the money available for distributions.
A key issue
This is a key issue to understand. Dividends have historically made up about 40% or so of the market's overall return. So for Gabelli to hit its 10% target, it will likely have to sell assets-capital gains or not. The same is true of Adams Express, though dividend income alone could get it closer to 6%.
BME's yield is about 4.5% based on its managed distribution policy of paying a $0.165 monthly dividend. That should be easy, right? Not so fast. The fund owns a large number of non-dividend paying companies like biotech outfits. Thus, it makes use of an options strategy to meet its income goals.
But, at the end of the day, it still has plenty of opportunity for capital appreciation to boost the fund's NAV because the distribution is well below the market's historical return figure. That said, if the health care sector tanks, a set dollar figure dividend policy will become an increasingly difficult target to hit. And what if the distribution were higher?
Eaton Vance Tax Managed Global Buy Write Opportunities Fund (NYSE:ETW ) has a managed distribution that leads to a yield of 9.8% or so. Going back to my hypothetical fund, you can see that it would be hard, on average, for ETW to increase its NAV much over time. It is, essentially, returning value to shareholders via the distribution. It's boosting its ability to pay distributions with an option strategy, but it's still dispensing a massive percentage of the return you'd expect, on average, each year.
Yes, it's the dividend
So, for a fund with a large distribution, the dividend may, indeed, be all that you should expect from a closed-end fund. Since these are just pooled investment vehicles, you should expect the high end of performance to be the average market return. And in that situation, if you are getting a high single digit yield or more, then all of your return is likely going to come from distributions. You shouldn't expect much more than that.
That's not a bad thing if you want to live off of your investments and are willing to accept capital preservation or low levels of capital growth as the trade off. However, you shouldn't go in thinking you'll get a 10% yield AND 10% capital appreciation over time. It's just not a realistic expectation over the long term.
Disclosure: The author is long BME.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.