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Jeff Margolin
Closed-End Fund Analyst
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  Early Thoughts on Tax-Loss Selling Season
Posted Under: Yield • Discounts • Income • Municipal • Equity

Jeff Margolin • Senior Vice President • Closed-End Fund Analyst

With the fourth quarter about a week and a half away, the topic of tax-loss selling and closed-end funds (CEFs) is one that is often on the forefront of CEF investors’ minds. Tax-loss selling is when investors sell securities to realize losses in order to offset gains within their portfolios. Tax-loss selling in the CEF structure often is most pronounced from roughly mid-November to the third week of December. It can lead to enhanced volatility and discounts to net asset value (NAV) widening during this period. The share price weakness and discount widening from tax-loss selling tends to be a short-lived, technical phenomenon that historically reverses course at the beginning of the following year when discounts to NAV often narrow and bargain hunters look to take advantage of the discounts and opportunities that were created during the previous quarter’s tax-loss selling.
Historically, tax-loss selling is most prominent during years in which the total returns for the majority of CEFs and categories within the CEF structure are lower for the year and therefore CEF investors have losses to take. With the average CEF up 9.65% year-to-date (YTD) through September 19th (according to Morningstar) on a share price total return basis, it has clearly been a positive year for the average CEF in 2014. Moreover, not only is the average CEF return positive by nearly 10% YTD, but it has also been a very broad rally with almost every category of the CEF marketplace positive for the year. Indeed, according to Morningstar, Emerging Markets is the only broad CEF category with a negative share price total return with the 18 CEFs in this category lower on average by 0.77% YTD, as of 9/19/14.

While a lot can change between now and the end of the calendar year, based on the fact that most CEFs have produced positive share price total returns so far in 2014, I believe conditions do not appear likely for there to be a lot of tax-loss selling in the CEF structure this year. However, it is important to state that while the CEF structure might not experience significant tax-loss selling in the fourth quarter, I believe there is still the possibility for some enhanced volatility as investors potentially begin the process of repositioning CEF portfolios ahead of 2015 when the Federal Reserve could finally begin to increase the Federal Funds rate, which has been at 0-0.25% since December of 2008. Also, while this has been a very solid year from a share price total return perspective for most CEFs, it does not mean CEF investors do not have losses in individual CEFs they have owned for more than a year, and therefore could still be candidates for tax-related selling. Either way, my primary focus as the fourth quarter commences is to continue to be an active proponent of CEF investors utilizing a four part “game plan” focused on adjusting CEF portfolios ahead of the potential increase in the Federal Funds rate that I outlined in this commentary piece from July 24, 2014: Click here to view 7/24/14 commentary.

Unlike open-end funds, which trade at prices based on a current determination of a fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Not all closed-end funds invest in income-producing securities and there is no guarantee that a fund’s yield will not fall regardless of whether the discount widens. In addition, as an investor’s total return will be impacted by the value of the fund’s shares, a widening discount will negatively affect total return.
Closed-end funds are subject to various risks, including management’s ability to meet a fund’s investment objective, and to manage a 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. 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 Wednesday, September 24, 2014 @ 2:34 PM • Post Link Share: 
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  Seeking Alpha with Biotechnology ETFs
Posted Under: ETFs
2014 is shaping up to be another strong year for the biotechnology industry and associated exchange-traded funds (ETFs). After declining nearly 20% from February to April, the NYSE Arca Biotechnology Index rebounded to new highs during the month of August, boosting year-to-date returns to 34.6% (through 8/31/14). As in years past, the industry's news flow contained a number of important announcements that significantly impacted near term returns for biotechnology stocks. While such stories have a tendency to frame investors' conceptions of biotechnology ETFs in terms of short-term, tactical trading opportunities, a compelling case can also be made for longer-term, strategic allocations to the biotechnology industry.
 
In many respects, biotechnology is unlike other industries. To a large extent, future earnings for these companies depend on innovation that pushes the boundaries of scientific understanding. On the one hand, tremendous resources can be expended on ventures that ultimately provide little or no payoff; on the other, scientific breakthroughs may create blockbuster revenue streams. Moreover, circumstances that are largely beyond the control of biotechnology companies, such as decisions made by regulators, can make or break a project.
 
Click here to continue reading.
Posted on Thursday, September 11, 2014 @ 1:45 PM • Post Link Share: 
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  Municipal Market Update - 2nd Quarter 2014
Posted Under: Municipal
Late last year, while many municipal market participants were predicting a second straight year of negative total returns for municipal bonds in 2014, we called for positive total returns for the full year while recommending that investors focus their attention on the intermediate portion of the yield curve and emphasized an investment orientation in lower investment grade rated bonds. Through the first half of 2014, the Barclays Municipal Bond Index returned 6.0%, including a positive 2.59% during the second quarter of 2014. The Barclays Revenue Bond Index and Non-Investment Grade Index sported even higher total returns of 6.59% and 7.53%, respectively. The FTA High Income SMA generated a total return, net of fees, of approximately 7.33%.
 
So what happened? What accounts for such strong year-to-date performance?  Click here to read the 2nd Quarter Municipal Update.
Posted on Friday, July 25, 2014 @ 5:43 PM • Post Link Share: 
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  Senior Loan & High Yield Review - 2nd Quarter 2014
Posted Under: Senior Loan • High Yield
During the second quarter of 2014, an accommodative Federal Reserve (the "Fed"), strengthening economic data and declining interest rates helped drive returns for equities and longer duration fixed-income assets. Investors continued to scrutinize the rhetoric from the Fed, attempting to gauge the potential pace and timing of prospective interest rate increases. The Fed’s bond buying program is now less than half of the $85 billion-per month program that it was at its peak, and as of the time of this commentary, the Fed has announced the nearly imminent completion of its bond buying at its forthcoming meeting in October.

Much like the first quarter of 2014, the return of leveraged loans, and to a lesser extent, high-yield bonds, underwhelmed relative to other, more rate sensitive, traditional fixed income asset classes in the quarter. As the yield on the 10-year treasury fell 19 basis points from 2.72% to 2.53% during the quarter, it should come as no surprise that longer-duration fixed-income assets were the strongest performers. However, as steadily improving economic data continues to surface, we continue to believe the Fed will have the motivation they require to complete the quantitative easing program and begin the process of raising rates. In the interim, with short-term interest rates remaining at all-time lows and corporate profits healthy, we maintain our positive outlook for the senior loan and high-yield markets.

For a discussion of notable events in the senior loan and high-yield market as well as an outlook for the future, click here to read the whole report.
Posted on Thursday, July 17, 2014 @ 8:30 AM • Post Link Share: 
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  The Other Discount Advantage
Posted Under: Yield • Discounts • Income • Equity
Jeff Margolin • Senior Vice President • Closed-End Fund Analyst

When an investor considers investing in a closed-end fund (CEF) that is trading on the secondary market, one of the attributes of the CEF structure that is often appealing is the ability to purchase shares of a fund at a discount to its net asset value (NAV). Due to the fact that CEFs are equity instruments with shares traded publicly throughout the trading day on an exchange such as the New York Stock Exchange (NYSE), and an investor purchases shares of a CEF at a share price which is independent from the fund’s underlying NAV, its share price can trade at a discount or premium to its NAV. Whereas a CEF’s share price is traded throughout the day on an exchange, a CEF’s NAV is only priced once a day after the market closes. Bear in mind, with open-end mutual funds, investors buy and sell shares at the fund’s NAV which is also priced once a day after the market closes. The ability to buy shares of a CEF at a discount to its NAV can potentially enhance an investor’s total return, should that share price begin to revert to the fund’s underlying NAV, and therefore one of the unique characteristics of the CEF structure is the ability to invest in shares of a fund trading at a discount to its NAV.

While I am also drawn to the CEF structure because of the opportunity to sometimes buy CEFs at a share price which is below its NAV and therefore it is at a “discount to its NAV,” particularly when a CEF can be purchased when it is trading at a wider than average historical discount to its NAV, there is another “discount advantage” that is often overlooked by CEF investors but I think is a big plus to the CEF structure. It is the yield-enhancing opportunity that occurs when buying income-producing assets at a discounted price. In other words, buying a CEF at a share price which is at a discount to its NAV enhances an investor’s yield relative to if they purchased those assets at the fund’s NAV. I think I can best illustrate this “yield-enhancing opportunity” with a specific example:
  • If an investor purchases a CEF at a share price of $10.00 per share and that fund’s NAV is also $10.00 per share the fund is trading at its NAV and not at a discount or premium. Now let’s assume this fund pays a distribution of $1.00 per share annually. In this example, the investor’s current distribution yield would be 10%. The $1.00 per share distribution divided by the purchase price of $10.00 per share equals 10%.
Now let me show an example of the yield-enhancing opportunity that occurs when buying a CEF at a discount to its NAV:
  • If an investor purchases a CEF at a share price of $9.00 per share and that fund’s NAV is $10.00 per share then the fund’s share price is trading at a 10% discount to its NAV. The fund’s NAV is still $10.00 per share and is able to generate the same $1.00 per share in annual distributions. However, because an investor purchases shares in this CEF at the $9.00 share price, their yield is 11.11% and not 10% as in the previous example. The $1.00 per share distribution divided by the purchase price of $9.00 per share equals 11.11%. As you can tell from this example, an investor has significantly enhanced their yield by purchasing this fund at a 10% discount to its NAV. 
Currently, there are many CEFs trading at a discount to NAV in the mid-single to high-single digit level and therefore are compelling yield-enhancing opportunities available in the secondary market of CEFs in my opinion. In fact, one category of the CEF marketplace I continue to like is the domestic equity category. Not only does First Trust still maintain a bullish view on the U.S. equity markets, but as of 5/19/14 the average domestic equity CEF was at a 6.52% discount to its NAV, which is much wider than where it was one year ago when the average discount to NAV was only 2.61%, according to Morningstar. Furthermore, investors in domestic equity CEFs can potentially enhance their distribution yields by purchasing funds at these relatively wide discounts to NAV.

Unlike open-end funds, which trade at prices based on a current determination of a fund’s net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Not all closed-end funds invest in income-producing securities and there is no guarantee that a fund’s yield will not fall regardless of whether the discount widens. In addition, as an investor’s total return will be impacted by the value of the fund’s shares, a widening discount will negatively affect total return.
Closed-end funds are subject to various risks, including management’s ability to meet a fund’s investment objective, and to manage a 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. 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 Wednesday, May 21, 2014 @ 3:12 PM • Post Link Share: 
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  Municipal Closed-End Funds: MNCEFT Closes Above 1600; Silent Rally Continues
Posted Under: Yield • Discounts • Income • Municipal

The First Trust Municipal Closed-End Fund Total Return Price Index (MNCEFT) closed above 1600 (1604.99 to be precise) on 5/15/14 for the first time since 5/24/13 when it closed at 1608.11. National municipal closed-end funds (CEFs) as measured by this index are now up 13.71% YTD and up 17.64% since 12/5/13, according to Bloomberg. As recently as 12/5/13 this index was at 1364.22. It closed above 1400 on 12/18/13, above 1500 on 2/10/14 and above 1600 on 5/15/14.

In the title above you might have noticed I used the word “silent” to describe this huge rally in municipal CEFs. I specifically used that word because owing to the 30%+ rally in the S&P 500 in 2013 coupled with the Dow Jones Industrial Average and S&P 500 recently hitting all-time highs, it has been easy for this municipal CEF rally to get lost in the shuffle. However, I suspect it would surprise a lot of investors to know that over the past six months through 5/15/14, national municipal CEFs, as measured by MNCEFT, have actually significantly outperformed the S&P 500 (15.20% for MNCEFT vs. 5.13% for the S&P 500 including distributions according to Bloomberg). Behind the rally in municipal CEFs has been a very conducive environment for municipal bonds and municipal CEFs including: very low leverage cost as a result of the federal funds rate being 0-0.25%, very compelling tax-free yields averaging north of 6% for leveraged municipal CEFs, demand for high quality tax-free investments and a lower than usual supply of municipal bonds, improving finances for many municipalities, declining interest rates and low inflation.

It was challenging last year when municipal CEFs were weak and I was making the case to investors to continue having some exposure to municipal CEFs as they were properly diversified across different categories of the CEF marketplace. But the significant rally the past six months is a good reminder of the importance of balance in a CEF portfolio, the importance of not selling into a panic (again with the caveat that as long as an investor is properly diversified) and the importance of taking advantage of these opportunities when they arise, as they did the second half of 2013.

What is my current view of municipal CEFs?
In my view, the primary risk for investors in municipal CEFs remains duration risk (duration is a measure of interest rate sensitivity). 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. Given the meaningful capital appreciation municipal CEFs have produced the past six months, I expect more of the potential total return going forward to come from the distributions municipal CEFs provide. 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 of 6.17% for national leveraged funds (as of 5/14/14 according to Morningstar), current wide discounts to NAV averaging 5.73% (as of 5/14/14 according to Morningstar) compared to discounts of only 1.43% a year ago and 2.26% three years ago and the likelihood most municipal CEFs will be 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 a fund’s investment objective, and to manage a 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 a 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 Friday, May 16, 2014 @ 3:18 PM • Post Link Share: 
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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.

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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.

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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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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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The Power of Closed-end Fund Distributions
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Senior Loan CEFs: Big Disparity Between Share Price and NAV Performance in 2013
My CEF Final Four
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Domestic Equity CEFs Still a Favored Category
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Share Prices Historically Track NAVs
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