I think WSJ is right some good deals
I've bought and sold some closed end funds (CEF) in the past but never really studied them closely until the last couple of days. Now 2 days of research doesn't make me an expert, so I'd appreciate any corrections to my little primary about CEFs. I found them potentially very interesting investment primarily because discounts on certain types of CEFs have widen considerably and reached multi year highs.
How Equity CEFs work.
From what I can tell, a company like Nueeven (the old name in CEFs) or Eaton-Vance, decide to start a new CEF. The come up with a theme and cool name like Enhanced Global Equity Income Opportunities and get their team of brokers and distributors to raise ~$1 billion by selling ~50 million shares at $20/share. The marketing pitch for equity CEFs is they pay a steady (or rarely increasing) income that is higher than you'd get with CDs or bonds. Generally they pay between $.10 to $.15 per month/share, which works out to be between 6-9% on the initial $20.
After paying front end loads and costs typically the funds end up with around $19/share in assets.
Now as we all know finding stocks that yield 6% isn't easy much less 9%, so pretty much all of these CEF employ a [-]gimmick [/-] strategy. One typical strategy is to use leverage by issuing preferred shares and using the borrowed money to juice up the returns.
Another strategy is to write covered calls either on individual issues or indexes like the S&P, NASDAQ, or international index like the FTSE. They use the option premium to make the monthly income payments. Finally, they all encourage dividend re-investments which provide another source of funds to pay current stockholders.
Now in rising market this all works out hunky dory. There is enough cash flow from dividends, option premium, dividend reinvestment along with taking some profits to make the monthly payments. In addition, the NAV raises slightly and the market price tracks the NAV (in some case they even sell for a modest 3-5% premium!). Susie and Joe investor receive their 8% income each month and everybody is happy, especially the issuers who collect their ~1% (or higher) expense ratio or $10 million on $1 billion fund.
Joe and Susie don't real care the funds trailed the S&P, Russell 3000, or EAFE.
In a bear or even a volatile market the situation changes, for funds with a high distribution level, there isn't enough income, and capital gains to harvest to pay out the monthly check. So rather than cut distributions, the funds return some of the paid in capital. This reduce the amount of assets available to generate income, which in turn makes next quarters distribution tougher to meet. Susie sees that price of her funds drop and for whatever reason decides to sell, since she can't redeem shares she has to find another investor. Since the market for funds that lose value is pretty small, the gap between the NAV and market price widens. This doesn't cause the fund manager much lost sleep cause they still collect their paycheck based on NAV, not market price or shareholder return.
CEFs Today
Still what has happen this summer has been pretty remarkable. Early in the year most of these Equity CEF (JPZ, JSN, EOI, ETB,ETW etc.) that used covered calls were trading near there NAV in some cases even a bit above, but since the summer the discount has widen to 13-15%. The NAV of these funds has barely changed typically remaining at about $19 +/- $1 for the last couple of years. Meanwhile the funds are distributing about .40 to .45 a quarter (8-9%) in income, cap gains (and some return of capital.). I (and evidently the fund operators) are puzzled why mildly bullish strategy like writing covered calls (which should benefit from increased volatility) is being punished.
The discount has widen for most other CEF, including some like AzDreamer own, ETG, that actually have increased distributions, but not as much as covered calls CEFs. Finally I did come across one speculative fund that I think shows the market is crazy. RMT Royce MicroCap Trust as the name implies invest in companies with less than $500 mil market capitalization. Run by fund family founder, it 14 year old fund with CAGR of 13.5% since
inception or a 5 bagger. On 12/31 2006 the NAV was $14.77 and the share price was $16.57 a 12% premium. This year the NAV is 13.57 but when you add back the $1.35 distribution the fund actual made money. However, Mr. Market thinks the fund is only worth $11.80 a 13% discount so a 25% swing in one year on virtually the same pool of assets.
Now, I am not completely sold on CEF since I don't like paying a high ER for mediocre performance, but I do like being able to buy $1 worth of stocks for $.85