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  Commodity ETFs and the Business Cycle
Posted Under: ETFs

 

 
Investor enthusiasm for non-gold commodity ETFs1 continued to wane during the first quarter of 2014, as net outflows accelerated to $922 million, following $1.785 billion in net outflows for 2013.2  This is unsurprising in light of the poor performance of many commodity indices and their related ETF over the past few years. However, investors may be selling out of commodity ETFs at (or near) a stage in the business cycle when the diversification benefits potentially provided by commodities ETFs may be most beneficial. In this blog entry, we’ll discuss how the relationship between commodity futures and the business cycle may provide a compelling reason for investors to consider adding commodity ETFs to a diversified portfolio of stocks and bonds.

In 2006, Gary Gorton and K. Geert Rouwenhorst published a study which compared the average returns of U.S. stocks, U.S. bonds, and a diversified portfolio of commodity futures during four different phases of the U.S. economic business cycle, based on the economic peaks and troughs identified by the National Bureau of Economic Research (NBER) from 1959-2004.3 The four phases in the study were determined by bisecting each period of NBER-identified "expansion" and "recession". The data showed that both stocks and bonds tended to perform better during the first half of economic expansions than they did during the second half, while the opposite was true for commodity futures, which tended to outperform during the second half of expansions (Table 1). Moreover, while stocks and bonds tended to produce negative returns during the first half of recessions, followed by positive returns during the second half, commodity futures tended to produce positive returns during the first half of recessions, followed by negative returns during the second half. Based on these observations, the study suggested that the long term diversification benefits offered by a portfolio of commodity futures were partly due to differences in performance during different phases of the business cycle.

During the most recent NBER-identified full business cycle, which began in November 2001 and ended in June 2009, there were important similarities and differences compared to the longer-term averages published by Gorton and Rouwenhorst.   The most obvious differences occurred during the early expansion phase, as returns for commodity futures far outpaced stocks and bonds, and during the late recession phase, as negative returns for commodity futures were more extreme than the longer-term average, even as returns for stocks were also negative (Table 2).

Perhaps the most significant similarity between returns from the recent business cycle and the longer-term averages was the positive return provided by commodity futures during the first half of the recession, while stock returns were negative.  Additionally, commodity futures outperformed stocks and bonds during the second half of the expansion phase, although the outperformance relative to stocks was less pronounced.

Of course, a major problem arises for those interested in applying a trading strategy to this information (which was recognized by the study's authors): NBER identifies the beginnings and ends of recessions and expansions several months after the fact. This makes it impossible for investors to know when the economy has reached an inflection point between expansion and recession, or when a midpoint of either has been reached.

Nevertheless, we can make a reasonable approximation about the phase(s) to which the U.S. economy may currently be closest. With the trough of the last NBER recession identified as June of 2009, and in light of relatively steady positive GDP growth over the past several quarters, we can reasonably assume that the U.S. economy is currently in a NBER expansion. If so, the current expansion is about 57 months old. According to NBER data, the average duration of the 11 expansions since 1945 (through the peak of the last expansion in December of 2007) was 58.4 months; the longest was 120 months (between March 1991 and March 2001). So, while it's not yet possible to identify the midpoint of the current NBER expansion, if it's anything like the previous eleven, there is a good chance the second half has already begun, or if it hasn’t (and the next recession is more than 57 months away), the midpoint is likely drawing near.

If this inference proves correct, the U.S. economy may be in the midst of (or about to enter into) the two phases of the NBER business cycle during which commodity ETFs could provide the greatest benefit to a portfolio of stocks and bonds. The second half of NBER expansions produced the highest average returns for commodity futures, while the first half of NBER recessions produced positive average returns for commodity futures, during a stage in which average returns for stocks and bonds were both negative.

Broad commodity indices have started 2014 with attractive first quarter gains, and we believe there are compelling reasons, including portfolio diversification, inflation expectations, and past business cycle analyses, for investors to review, and perhaps increase, exposure to commodity ETFs within their asset allocation models.

You should consider a fund’s investment objectives, risks, and charges and expenses carefully before investing. You can download a prospectus or summary prospectus by visiting www.ftportfolios.com, or contact First Trust Portfolios L.P. at 1-800-621-1675 to request a prospectus or summary prospectus which contains this and other information about a fund. The prospectus or summary prospectus should be read carefully before investing.

Investors buying or selling ETF shares on the secondary market may incur customary brokerage commissions. Market prices may differ to some degree from the net asset value of the shares. Investors who sell fund shares may receive less than the share's net asset value. Shares may be sold throughout the day on the exchange through any brokerage account. However, unlike mutual funds, shares may only be redeemed directly from the fund by authorized participants, in very large creation/redemption units. A fund’s shares will change in value, and you could lose money by investing in a fund. One of the principal risks of investing in a fund is market risk. Market risk is the risk that a particular security owned by a fund, fund shares or the market in general may fall in value.

The trading prices of commodities futures fluctuate in response to a variety of factors which will cause a fund’s net asset value and market price to fluctuate in response to these factors. As a result, an investor could lose money over short or long periods of time. In addition, the net asset value of a fund over short-term periods may be more volatile than other investment options because of a fund’s significant use of financial instruments that have a leveraging effect. Futures instruments may be less liquid than other types of investments. The prices of futures instruments may fluctuate quickly and dramatically and may not correlate to price movements in other asset classes.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

1 For the sake of clarity, this article uses the term "ETF" to refer to all exchange-traded products (1940 Act exchange-traded funds, exchange-traded notes, commodity exchange-traded securities, etc.).
2 Morningstar Direct.
3 Gorton, G. and K. Geert Rouwenhorst (2006). "Facts and Fantasies about Commodity Futures." Financial Analysts Journal, vol. 62, no. 2: 47-68.

To download a PDF of this post, please click here.

Posted on Thursday, April 10, 2014 @ 3:47 PM • Post Link Share: 
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  Year-To-Date Performance of Municipal Closed-End Funds Shows the Importance of Balance
Posted Under: Yield • Discounts • Income • Municipal • Equity • CEFs

2013 was a remarkable year for domestic equities. Not only was the Standard & Poor’s 500 Index up 32.37% according to Bloomberg, but it achieved these results with very little downside volatility. Indeed, August was the only negative month for the S&P 500 in 2013. With such robust returns for equities coupled with a rise in long-term interest rates last year, it is to be expected that investors could lose sight of the importance of building balanced, diversified closed-end fund (CEF) portfolios and instead be mostly focused on equities and equity CEFs. The speed and degree with which investors sold both individual municipal bonds as well as municipal CEFs during the spring and summer of 2013 illustrates this point.
However, just because municipal bonds and municipal CEFs were clearly out of favor with investors for most of 2013, it did not mean there was not value in the underlying asset class and in municipal CEFs. This was precisely why I continued to advocate CEF investors maintain some exposure to municipal CEFs as the distribution rates, distribution stability (for the majority of municipal CEFs), valuations, low leverage cost and high credit characteristics were still compelling enough to warrant they be part of a diversified, balanced portfolio of CEFs.
While I suspect some readers of this blog and CEF commentary page may have doubted the wisdom behind this thesis, the recent performance of municipal CEFs illustrates the importance of maintaining balance in a CEF portfolio even when one of the categories you own might be out of favor. This is particularly relevant in light of the choppy start to the year for the S&P 500 which is up 0.50% year-to-date (YTD) as of 3/28/14 according to Bloomberg.  National municipal CEFs, as measured by the First Trust Municipal Closed-End Fund Total Return Price Index (MNCEFT), are up 8.61% YTD through 3/28/14 and up 12.37% since 12/5/13. Even with the very strong total returns since early December, I believe valuations for municipal CEFs remain attractive as the average discount to NAV was 6.08% as of 3/28/14 according to Morningstar. The average was 0.91% one year ago and 0.97% three years ago according to Morningstar. Furthermore, with the Federal Reserve likely to keep the federal funds rate at 0-0.25% through all of 2014, leverage cost for levered municipal CEFs should remain low and help most municipal CEFs to maintain their very attractive distributions. The average national, leveraged municipal CEF had a distribution rate of 6.39% as of 3/28/14 according to Morningstar. A 6.39% distribution rate is a taxable equivalent distribution rate of 9.83% for someone in the 35% tax bracket.
In my view, the primary risk for investors in municipal CEFs remains duration risk. This is why I continue to advocate that CEF investors build portfolios that blend municipal CEFs with shorter duration senior loan CEFs as well as limited duration multi-sector CEFs and domestic equity CEFs as a way to mitigate some of the duration risk inherent in municipal CEFs. The potential for higher short term interest rates (and therefore higher leverage cost) sometime in mid-2015 is something owners of leveraged municipal CEFs should be watching closely. However, for now, while municipal CEFs clearly have duration risk, I believe with average tax-free distribution rates north of 6%, current wide discounts to NAV and the likelihood most municipal CEFs are able to maintain their distributions this year and into 2015 as the Federal Reserve keeps the fed funds rate at a rock bottom 0-0.25%, investors are being compensated for the duration risk they are assuming.

The performance of the First Trust Municipal Closed-End Fund Index is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. The First Trust Municipal Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the U.S. municipal closed-end fund universe.  An index cannot be purchased directly by investors.
Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.
All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Monday, March 31, 2014 @ 2:09 PM • Post Link Share: 
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  Mid-Quarter Update: Good Start to 2014 for Many Categories of CEF Marketplace; Still Compelling Values Available
Posted Under: Yield • Discounts • Income • Municipal • Equity • CEFs

Many categories of closed-end funds (CEFs) are off to a good start to the year. Investors took advantage of the big discounts to net asset value (NAV) and attractive yields available in the secondary market which helped push the average CEF up 2.57% the first 6 weeks of the year as measured by the First Trust Closed-End Fund Composite Total Return Price Index (UPCEFT) as of 2/14/14. In my quarterly CEF commentary piece from January, I discussed how there were as many compelling opportunities in the secondary market for CEF investors as there had been at any time since early 2009 from my standpoint based on, among other factors, very compelling valuations and attractive yields as leverage cost are still very low as the Fed continues to keep the Federal Funds rate at a rock bottom 0-0.25%. Click here to view commentary.
 
As of 2/14/14, national municipal CEFs are up 6.83% as measured by the First Trust Municipal Closed-End Fund Total Return Price Index (MNCEFT), taxable fixed income CEFs are up 2.71% as measured by the First Trust Taxable Closed-End Fund Total Return Price Index (TXCEFT) and equity CEFs are up 1.59% as measured by the First Trust Equity Closed-End Fund Total Return Price Index (EPCEFT). Even with the solid start to the year for many categories of the CEF marketplace, I still find valuations and yields very compelling as underlying NAVs for many CEFs (particularly fixed income funds) have also performed well which has helped to keep discounts to NAV wide and attractive. Indeed, while average discounts to NAV for all CEFs have narrowed slightly since the end of 2013 from 7.33% to 6.59% as of 2/14/14 (according to Morningstar), they are still wider than where they were a year ago when discounts were 0.99%, three years ago at 2.51% and five years ago at 5.92% (according to Morningstar).

Furthermore, average yields remain very compelling at 6.72% (as of 2/14/14 according to Morningstar) compared to the average yield of 6.13% from one year ago as the theme of CEFs benefiting from low leverage cost remains very much intact. I see distributions for most CEFs likely remaining stable in 2014 as the majority of CEFs continue to earn a generous spread between leverage costs and the rates they can earn on borrowed proceeds. With the Fed unlikely to raise the Federal Funds rate until 2015 (based on what they have communicated to investors), this positive backdrop for the CEF structure remains in place.

In short, while many categories of the CEF marketplace are off to a good start to 2014, as the second half of the quarter commences there still remain many compelling opportunities available in the secondary market for CEF investors as average discounts to NAV remain wide, yields remain high and fundamentals for asset classes I favor including domestic equities, senior loans, high yield corporate bonds and municipal bonds remain sound. (Please see January CEF Commentary and Blog from 1/9/14 for more on fundamentals of these asset classes.)

The performance of the First Trust closed-end fund indexes is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. The First Trust Composite Closed-End Fund Index is a composite index of the municipal, taxable fixed income and equity indexes and is intended to provide a capitalization weighted representation of the entire U.S. closed-end fund universe. The First Trust Municipal Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the U.S. municipal closed-end fund universe. The First Trust Taxable Fixed Income Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the taxable fixed income closed-end fund universe. The First Trust Equity Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the equity based closed-end fund universe. An index cannot be purchased directly by investors.
Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.
All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Tuesday, February 18, 2014 @ 10:53 AM • Post Link Share: 
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  Preparing for the Unexpected with Commodity Futures ETFs
Posted Under: ETFs

Three straight years of negative returns for broad commodity benchmark indices, such as the Dow Jones-UBS Commodity Total Return Index, have led some investment advisors (and their clients) to begin questioning the rationale for including commodity futures ETFs in their asset allocation models. Relatively tame inflation expectations seem to support these doubts, as commodities are often thought of as a hedge against inflation. However, the fact that inflation expectations are so low may actually highlight one of the most important reasons for maintaining (or adding) a strategic allocation to commodity futures ETFs: in order to hedge against unexpected inflation.

Unexpected inflation is a risk worth hedging, in our opinion, because it tends to have a negative impact on both stocks and bonds. For example, when inflation is accurately forecasted, manufacturing companies can utilize futures contracts to lock in their future costs for certain raw materials, in order to manage their profit margins. However, when input costs rise unexpectedly, profit margins may be compressed for companies that have difficulty passing these cost increases along to their customers, which, in turn, tends to hurt stock prices.

Bondholders are negatively impacted by unexpected inflation as well, since bond yields are set by the market with an embedded inflation expectation. When inflation increases unexpectedly, the real value of bond interest payments is reduced, which may also negatively impact bond prices, as the market requires higher nominal yields.

Similar to stocks and bonds, the prices of commodity futures also have embedded inflation expectations, but unlike stocks and bonds, commodity futures prices tend to be positively impacted by unexpected inflation increases. This relationship enables investors to potentially utilize commodity futures and related ETFs as an effective hedge against unexpected inflation.

Of course, it’s difficult to make a strong case for when unexpected inflation may show up, which is ultimately what makes it unexpected. While there are certainly conditions in place that could eventually lead to higher levels of inflation, First Trust’s forecast for year-over-year US CPI growth of 1.8% in 2014 and 2.3% in 2015 is only slightly higher than the median forecast among Bloomberg contributors (1.6% for 2014 and 2.0% for 2015). But this underscores why we believe it makes sense to include a strategic allocation to commodity futures ETFs in an asset allocation model: not as a tactical play based on our expectation of unexpected inflation, but as a tool to manage the risk of unexpected inflation, which, by definition, you don’t see coming.

You should consider a fund's investment objectives, risks, and charges and expenses carefully before investing. You can download a prospectus or summary prospectus, or contact First Trust Portfolios L.P. at 1-800-621-1675 to request a prospectus or summary prospectus which contains this and other information about a fund. The prospectus or summary prospectus should be read carefully before investing.

The Dow Jones-UBS Commodity Index is made up of exchange-traded futures on physical commodities and represents 20 commodities, which are weighted to account for economic significance and market liquidity. Indexes are unmanaged and an investor cannot invest directly in an index.

Investors buying or selling ETF shares on the secondary market may incur customary brokerage commissions. Market prices may differ to some degree from the net asset value of the shares. Investors who sell fund shares may receive less than the share’s net asset value. Shares may be sold throughout the day on the exchange through any brokerage account. However, unlike mutual funds, shares may only be redeemed directly from the fund by authorized participants, in very large creation/redemption units. A fund’s shares will change in value, and you could lose money by investing in a fund. One of the principal risks of investing in a fund is market risk. Market risk is the risk that a particular security owned by a fund, fund shares or the market in general may fall in value.

The trading prices of commodities futures fluctuate in response to a variety of factors which will cause a fund’s net asset value and market price to fluctuate in response to these factors. As a result, an investor could lose money over short or long periods of time. In addition, the net asset value of a fund over short-term periods may be more volatile than other investment options because of a fund’s significant use of financial instruments that have a leveraging effect. Futures instruments may be less liquid than other types of investments. The prices of futures instruments may fluctuate quickly and dramatically and may not correlate to price movements in other asset classes.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

Posted on Monday, February 10, 2014 @ 3:28 PM • Post Link Share: 
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  The Power of Closed-end Fund Distributions
Posted Under: Yield • Income • CEFs

 

Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.” Long-term investors in closed-end funds (CEFs) are keenly aware of this principle. The majority of CEFs have the goal of distributing current income as their primary investment objective and historically the majority of a CEF’s total return has come from the distributions it makes. This doesn’t mean an individual CEF or category of CEFs cannot earn capital appreciation along with distributions, rather as the data below indicates it simply means over long periods of time the majority of the total return CEFs historically provide comes from the distributions.

This chart displays data points which clearly show the power of CEF distributions adding up over time and making up all of the positive return the First Trust CEF Indexes have earned over the past eight years. Each First Trust Index below shows two returns. The blue bars exclude distributions and only include the price return. The bars shaded in green are total return and include the price return plus the distributions.
The data is very compelling. It clearly illustrates the power of CEF distributions compounding over time and contributing significantly to the total return of these broad based CEF indexes. When putting this chart together I used data which goes back almost eight years and therefore includes the significant price downturn experienced in 2008. If I had used data which only goes back five years it would still show the majority of the return earned in these indexes coming from the distributions, however it would show some of the return coming from capital appreciation as well. For example, the First Trust Closed-end Fund Composite Price Index (UPCEF) had a cumulative return of 41.67% from 12/31/2008-12/31/2013. The First Trust Closed-end Fund Composite Total Return Price Index (UPCEFT) generated a cumulative total return of 110.04% during the same five year period (12/31/2008-12/31/2013).

Whether looking at this total return data over five years or eight years the point remains the same. The distributions CEFs make on a regular basis can have a significant impact on the total returns investors have historically earned in CEFs. If an investor owns one CEF or a portfolio of dozens of funds, I believe it is critical to always consider the distributions when calculating the return as in all likelihood the distributions will make up a substantial part of the total return.

The chart is for illustrative purposes only and not indicative of any investment. Past performance is no guarantee of future results. The First Trust Composite Closed-End Fund Index is a composite index of the municipal, taxable fixed income and equity indexes and is intended to provide a capitalization weighted representation of the entire U.S. closed-end fund universe. The First Trust Municipal Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the U.S. municipal closed-end fund universe. The First Trust Taxable Fixed Income Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the taxable fixed income closed-end fund universe. The First Trust Equity Closed-End Fund Index is a capitalization weighted index designed to provide a broad representation of the equity based closed-end fund universe. An index cannot be purchased directly by investors.
Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.
All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Tuesday, January 21, 2014 @ 3:34 PM • Post Link Share: 
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  Following Solid December, Municipal CEFs off to Good Start in 2014
Posted Under: Yield • Discounts • Income • Municipal • CEFs

While the average municipal closed-end fund (CEF) was lower by 13.42% on a share price total return basis in 2013 (NAVs were lower by 6.88% on a total return basis) according to Morningstar, performance has improved recently. On September 3, 2013 I wrote a blog piece entitled “Still out of Favor but with Compelling Yields and Valuations” which discussed that municipal CEFs were still out of favor with investors despite the value in municipal bonds, attractive discounts to NAV and very compelling tax-free yields municipal CEFs offered. The September to November period was a fairly stable one for most municipal CEFs, however by December investors had finally begun to take advantage of the very compelling yields and discounts to NAV. In fact, the First Trust Municipal CEF Index (MNCEFT) was up 2.26% during the month of December. The positive momentum and bargain hunting has continued into 2014 with MNCEFT up 2.24% through 1/8/14 according to Bloomberg. The index closed at 1443 on 1/8/14 which represents its highest closing price since 7/12/13 according to Bloomberg.

While the primary risk in municipal CEFs in my opinion remains duration risk (aka interest rate risk) and investors need to be aware of it, municipal CEFs continue to also have many positive characteristics including average discounts to NAV of 6.20% as of 1/9/14 (a year ago they were at an average premium to NAV of 3.22% according to Morningstar), average distribution yields of 6.37% as of 1/9/14 (a year ago the average distribution yield was 5.17% according to Morningstar) and they continue to benefit from very low leverage cost which should remain low through 2014 given the fact the Federal Reserve has indicated they do not intend to raise the Federal Funds rate until 2015. Furthermore, despite a few high profile municipal bond defaults, such as Detroit’s bankruptcy filing, the number of bond issues that defaulted in the S&P Municipal Bond Index actually fell for the third straight year in 2013, according to S&P Dow Jones Indices. The number of defaults in each year were as follows: 2013 (23 issues/0.107% default rate); 2012 (30 issues/0.144% default rate); and 2011 (46 issues/0.227% default rate).
Despite the inherent interest rate risk in municipal CEFs, I continue to believe the positive characteristics discussed above are compelling. Given the sell-off in municipal CEFs which occurred in 2013, I believe the yields and valuations make it worth taking on the interest rate risk as part of a diversified, balanced CEF income portfolio which should also include shorter duration credit sensitive funds such as senior loan funds, limited duration funds, high yield funds and domestic equity funds.

Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Thursday, January 09, 2014 @ 2:45 PM • Post Link Share: 
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  Senior Loan CEFs: Big Disparity Between Share Price and NAV Performance in 2013
Posted Under: CEFs

 
This graph helps to visually articulate the blog post below. It is a YTD total return graph with the orange line representing the share price total return performance for all senior loan CEFs. The blue line shows the YTD NAV total return performance for all senior loan CEFs.

As you can see, the NAV performance of the universe of senior loan CEFs has been steadily trending higher all year and is up over 8% YTD. You can also see how despite this solid and steady underlying NAV performance for senior loans, in late May/early June the share prices of the universe of senior loan CEFs began to sell off and didn’t stabilize until early September.

The wide gap and divergence in performance which began in the Spring/Summer represents the “discount opportunity” that I firmly believe exist in the senior loan CEF category. Senior loan NAVs are performing very well but yet this is not being recognized in the share prices of the same universe of senior loan CEFs. While this significant disparity in YTD performance between share prices and NAVs might be frustrating to investors, ultimately I believe it represents an opportunity, as historically the market does become more efficient and begin to recognize this opportunity.



Following 2012, a year in which the average senior loan closed-end fund (CEF) was up 22.63% on a share price total return basis according to Morningstar, the average senior loan CEF is up a miniscule 0.03% year-to-date (YTD) also on a share price total return basis according to Morningstar as of 12/9/13. However, the slightly positive share price total return earned thus far in 2013 only tells part of the story. While share price total returns are barely positive YTD, underlying net asset value (NAV) performance has been much better. In fact, according to Morningstar, as of 12/9/2013, the average senior loan CEF has a NAV total return of 8.43%. This high single digit NAV total return reflects the positive fundamentals which continue to exist in the senior loan asset class, including a default rate of only 1.48% as of the end of November according to S&P. It also reflects the continued demand investors have for the senior loan asset class given their limited duration risk and compelling income.

Furthermore, while not at a meaningful discount to par, the average loan in the S&P/LSTA Leveraged Loan 100 Index is at a slight discount nonetheless trading at 98.14 as of 12/9/2013 according to Bloomberg. While not necessarily a growth story, historically senior loans have traded right around par in environments in which the economy is growing and interest rates are trending higher such as the 2004-2006 period. Indeed, from 1/2/2004 to 12/31/2006 which was the last time both short and long-term interest rates trended higher, the S&P/LSTA Leveraged Loan 100 Index stayed in a very tight range that entire three year rising interest rate period, hitting a low of 99.82 on 1/2/2004 and a high of 101.32 on 3/18/2005, while distributing compelling income the entire time.

I suspect some of you might be reading this blog thinking to yourself, “Why would I care that NAV performance for the average senior loan CEF is up over 8% YTD? I own my senior loan CEFs at the share price, not the NAV and share prices are barely positive YTD on a total return basis.” While of course I recognize that investors in CEFs own them at the share price and not the underlying NAV (as they would an open-end mutual fund), ultimately as I discussed in my blog from 8/28/2013 entitled “Share Prices Historically Track NAVs,” the underlying NAV performance of a CEF is very important as historically share prices have tended to gravitate towards the underlying NAV. While this year might have been frustrating for investors in senior loan CEFs as share prices underperformed NAVs significantly, historically while there are these periods when the marketplace is inefficient and there is a wide disparity between share price and NAV performance, it can also represent a compelling opportunity as share prices historically do track underlying NAVs over time.

As we enter 2014, the underlying fundamentals of senior loans remain strong as mentioned above. Furthermore, as a result of share prices underperforming  NAVs by such a significant amount, average discounts to NAV are a significant 6.70% according to Morningstar as of 12/9/2013 and represent some of the most compelling valuations seen in the senior loan CEF category since the summer of 2011 when the U.S. debt was downgraded. In addition to compelling fundamentals and valuations for senior loans and senior loan CEFs, yields also remain compelling. To that end, even with several senior loan CEFs recently reducing distributions as spreads have narrowed, the average senior loan CEF still yields a significant 7.12% as of 12/9/2013 according to Morningstar.

While I recognize that 2013 has been a frustrating year to this point for some investors in senior loan CEFs given the very solid NAV total return performance but yet barely positive share price total return performance, ultimately I think the share price total return performance reflects the fact that many CEFs became out of favor with investors (particularly in the second and third quarters) as the equity markets continued to move higher and investors indiscriminately sold shares of many categories of the CEF marketplace without considering the strength and characteristics of the underlying asset class as was the case with senior loan CEFs. It is my view that eventually the secondary market for CEFs will become more efficient and investors will recognize the compelling valuations, fundamentals and yields which still exist in senior loan CEFs. I continue to believe they should be part of a diversified CEF portfolio which should also include limited duration, high yield, domestic equity and municipal CEFs.

Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

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Posted on Tuesday, December 10, 2013 @ 4:25 PM • Post Link Share: 
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  My CEF Final Four
Posted Under: Yield • Discounts • CEFs

There are many different ways to approach investing in closed-end funds (CEFs) in the secondary market. One question I often get is “What factors do you think an investor should consider before investing in a CEF?” While there is no right or wrong answer to this question, from my standpoint the four most important criteria an investor should consider are discussed below.

  • Attractiveness of the underlying asset class: Just like an open-end fund (commonly known as a mutual fund) a closed-end fund can provide investors with professional management, diversification and exposure to many different asset classes depending on the objective of the fund. However, unlike an open-end fund where an investor buys and sells shares in the fund at net asset value (NAV) once a day after the market closes, closed-end fund investors purchase common shares of a fund on an exchange such as the NYSE throughout the trading day. These common shares are traded independently of the underlying NAV of the fund. While a closed-end fund’s common shares trade on an exchange and independent from the underlying NAV of the fund, ultimately over time share prices usually tend to gravitate toward the underlying NAV of the fund. Therefore, from my standpoint, the attractiveness of the asset class the fund is invested in is extremely important in determining how the common shares will trade. This is precisely the reason I have had the highest conviction level in domestic equity CEFs and senior loan CEFs for the past two years as I have believed, and continue to believe, the fundamentals and valuations of both of these asset classes remain compelling.
  • Valuation: The price an investor pays for any security should always be one of the most important criteria they consider when deciding to invest and a closed-end fund is no different.  As it relates to the CEF structure, I think investors should focus on the share price of a fund relative to the fund’s NAV. From my standpoint, investing in a CEF simply because the price is at a discount to its NAV is not all investors should consider. Rather, I prefer to focus on funds which are not only trading at a discount to NAV but also at a discount to NAV which is wider than the fund’s historical average. When a fund trades at a discount to NAV which is wider than its historical average, it could be an indication that there is real value in a fund and the market has yet to appreciate that value. The website CEFA.com provides historical discount to NAV or premium to NAV information for CEFs.
  • Sustainability of the distribution: Considering the fact that many CEFs have the goal of distributing current income as their primary investment objective and considering the fact that many investors choose to invest in CEFs because of the compelling distributions they historically provide, the sustainability of a CEF’s distribution is another key criterion on which investors should focus. A CEF is required to publically file its earnings rate per share data with the Securities and Exchange Commission (SEC) two times a year. Investors can compare this data with a fund’s current distribution to get a sense if the distribution is likely to be maintained, decreased or increased. The website Cefconnect.com is another useful resource for this information. While the sustainability of a fund’s distribution is one of the four most important criteria I think CEF investors should consider, it is important to note that owing to the floating rate nature of the interest on senior loans, distributions can be somewhat volatile from month to month for senior loan CEFs. Presently, given the attractiveness I see in the senior loan asset class, wider than average discounts to NAV available in many senior loan CEFs as well as the limited duration risk of the senior loan asset class, I am willing to accept some fluctuation in the distributions of senior loan CEFs.
  • NAV track record: The best way to judge how a portfolio manager or portfolio management team is doing in managing the assets they have been entrusted with is to analyze a fund’s net asset value performance relative to its peer group and benchmark. Bear in mind roughly 70% of all CEFs employ the use of leverage and most benchmarks CEFs compare themselves to are unleveraged. Leverage enhances NAV performance in an up market but detracts from NAV performance in a down market. The website Morningstar.com provides detailed NAV performance data for CEFs as does CEFA.com and Cefconnect.com. I prefer to focus on CEFs where the portfolio manager has consistently delivered NAV performance in roughly the top third of his or her peer group for as long as they have been managing the fund. The reason the NAV performance of a CEF is an important criterion investors should consider before investing in a CEF is because, as I stated above, over time the share price of a CEF tends to gravitate towards a fund’s underlying NAV.

While there are other factors CEF investors should consider before investing in a CEF including leverage structure, composition of a fund’s distribution, average daily volume, etc., ultimately I believe the four factors discussed above are the most important and therefore makeup my “CEF Final Four.”

Closed-end funds are subject to various risks, including management’s ability to meet the fund’s investment objective, and to manage the fund’s portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors’ perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

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Posted on Tuesday, November 12, 2013 @ 12:45 PM • Post Link Share: 
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  Modest Improvement in Many CEF Categories; Potential for Tax-loss Selling
Posted Under: Yield • Discounts • CEFs
The wider than average discounts to net asset value (NAV), compelling yields and the recent announcement from the Federal Reserve that it is not going to begin reducing its bond purchasing program known as Quantitative Easing just yet as many market participants had expected as well as their firm commitment to keep short-term interest rates very low at 0-0.25% for a considerable time (likely to 2015) has helped to lead to modest improvement in the share price performance of many fixed-income closed-end funds recently. For example, according to Morningstar, high yield CEFs are up 2.84% in the past month, limited duration CEFs are up 3.46% over the past month and national leveraged municipal CEFs are up 3.77% over the past month (all data is on a share price total return basis). Even with the recent improvement in share price total return performance, the average fixed income closed-end fund (CEF) is lower by 8.87% year-to-date (YTD) while all equity CEFs remain positive YTD on a share price total return basis by 8.70% according to Morningstar.

I believe the fact the Federal Reserve again reiterated that they don’t intend to raise the Federal Funds level anytime soon remains a significant positive factor for the CEF structure as roughly 70% of all CEFs employ the use of leverage and of those 70% the overwhelming majority of funds borrow at rates which are pegged off of some short term benchmark. With the Federal Funds rate remaining at 0-0.25% it means leverage cost should also remain very low for the overwhelming majority of funds which are employing the use of leverage and this dynamic helps funds to be able to continue to deliver very high income to shareholders. In fact, partially as a result of this dynamic, the average CEF has a share price distribution yield of 6.75% which is higher than the 1 year average yield of 6.21% and the 3 year average yield of 6.46% according to Morningstar.

In addition to these compelling yields and the fact that leverage cost should remain low for most CEFs until the Fed begins to raise the Federal Funds rate (which may not be until 2015), average discounts to NAV still remain wider than historical averages for most categories of the CEF marketplace. The average discount to NAV for all CEFs according to Morningstar is 6.62%. Much wider than the 1 year average premium to NAV of 0.30%, three year average discount to NAV of 1.42% and 10 year average discount to NAV of 3.43%. Based on the compelling fundamentals, yields and valuations, I continue to advocate CEF investors have diversified exposure to domestic equity CEFs, shorter duration credit sensitive funds such as senior loan, limited duration and high yield CEFs and municipal CEFs. (See blogs from 9/16/13, 9/3/13 and 8/16/13 for more on these categories.)

While the recent reiteration from the Fed that they don’t intend to raise the Federal Funds rate anytime soon remains a positive for many CEFs as it keeps leverage cost low and yields, fundamentals and discounts to NAV remain attractive for the categories of the CEF marketplace I continue to favor (see paragraph above), there is the potential for enhanced volatility for many CEFs towards the end of the fourth quarter due to the potential for tax-loss selling. Tax-loss selling is when investors sell securities to realize losses in order to offset gains within their portfolios. Tax-loss selling tends to be more pronounced in CEFs in years when investors have losses to take and when investors have gains in parts of their portfolios they wish to offset. Given the fact that the universe of 189 taxable fixed income CEFs is lower on average by 4.55% YTD on a share price total return basis according to Morningstar and that the universe of 208 municipal CEFs is lower by 12.46% YTD on a share price total return basis according to Morningstar coupled with the fact that it has been a very good year for equities thus far in 2013 (YTD the S&P 500 Index is up 21% according to Bloomberg) means this year could see more tax-loss selling in CEFs than in recent prior years.

While it is hard to know when it will begin and how long it will last, typically tax-loss selling tends to occur from mid-November through mid to late December. Historically, when tax-loss selling is prevalent, discounts to NAV widen. The share price weakness and discount widening from tax-loss selling tends to be a short-lived, technical phenomenon that historically reverses at the beginning of the following year in January and February when discounts to NAV tend to narrow and share prices tend to bounce back as the tax-loss selling is over and investors look to take advantage of the discounts and opportunities that were created during the prior months’ tax-loss selling.

I believe tactical and CEF investors who tend to actively trade their CEF positions should have some cash on hand heading into to November and December should we experience weakness and discount widening as a result of tax-loss selling and be prepared to take advantage of the opportunities which present themselves as a result of tax-loss selling. Longer-term CEF investors who tend not to actively trade their positions but rather usually hold during periods of short term volatility should be aware that there could be some short-term volatility and weakness as a result of tax loss selling but also be aware that it tends to be short-lived and historically the short-term weakness associated with tax-loss selling tends to become short-term strength at the beginning of the following year once the tax-loss selling is over and investors seek to take advantage of the opportunities it creates.

All data is through 9/25/13.

Past performance is no guarantee of future results. Closed-end funds are subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors' perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund's net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Friday, September 27, 2013 @ 11:14 AM • Post Link Share: 
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  Domestic Equity CEFs Still a Favored Category
Posted Under: Equity • CEFs

With all of the volatility in fixed-income closed-end funds (CEFs) the last four months, it may have been overlooked that one category of the CEF marketplace which continues to perform well and remains one of two categories I have had the highest conviction level in since January 2012, is domestic equity CEFs. (Senior loan CEFs is the other category I have had the highest conviction level in since January 2012.) Indeed, year-to-date (YTD) through 9/13/13, the Morningstar universe of 119 domestic equity CEFs is up 9.44% on a share price total return basis. The same universe is up 12.71% on a net asset value (NAV) total return basis.

My thesis for liking domestic equity CEFs has been centered around five key factors including: strong fundamentals for domestic equities, a market multiple which is below historical averages, compelling yields among domestic equity CEFs, modest growth in the U.S. economy and wider than average discounts to NAV available among the universe of 119 domestic equity CEFs. Despite very solid performance for domestic equity CEFs the past couple of years, it still remains a category I have a high conviction level in as I believe all five of these key factors remain in place.
While the U.S. economy may not be booming, it is growing modestly (2nd quarter GDP growth was 2.5%) and that coupled with strong corporate balance sheets and global growth should help propel earnings per share (EPS) growth for the S&P 500 Index to 6.02% in 2013 and 10.87% in 2014 according to Bloomberg. Furthermore, even with the 18.36% increase in the S&P 500 index YTD through 9/13/13, according to Bloomberg the S&P 500 trades at an estimated P/E multiple of 13.74 based on 2014 EPS estimates. This is below the 20 year average P/E multiple of 19.66 and the 50 year average P/E multiple of 16.53.

Furthermore, as of 9/13/13, according to Morningstar the universe of domestic equity CEFs is trading at an average discount to NAV of 6.16% which is wider than its one year average discount of 4.22%, its three year average discount of 3.57% and its ten year average discount of 3.43%. Lastly, the average distribution yield among all 119 domestic equity CEFs remains a compelling 7.09% as of 9/13/13 according to Morningstar.
In short, based on the continued positive fundamentals of the underlying asset class of domestic equities, compelling valuation in the asset class as well as the CEF structure, an economy which continues to grow modestly and yields which remain attractive, I still believe domestic equity CEFs should be part of a diversified CEF portfolio.

Past performance is no guarantee of future results. Closed-end funds are subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors' perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund's net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.
All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

To download a PDF of this post, please click here.

Posted on Monday, September 16, 2013 @ 2:57 PM • Post Link Share: 
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These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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