In the search for income, don't chase payouts.
Many mainstream investors are unfamiliar with closed-end funds, or CEFs, but record-low interest rates and the never-ending search for yield have pushed people outside their comfort zones and into this often misunderstood (and misused) investment vehicle. It's easy to be wooed by distribution rates that often exceed 10% each year, but buying a fund solely for its stated payout is misguided. There are many great reasons to add CEFs to a portfolio (income generation is certainly one), but investors should avoid buying "yield" at any price. Because distribution rates and premiums go hand in hand, a high payout generally means the fund will trade at a narrow discount or (more likely) a high premium. (A quick note: Because CEFs distribute income, capital gains, and return of capital, it is incorrect to refer to the payout as a "yield"; it should be referred to as a "distribution.")
While we generally avoid blanket investment rules, we are firm in our belief that investors have no business purchasing a fund selling at a double-digit premium--the risk of capital loss is just too great. Unfortunately for some investors, we've seen an abundance of examples in recent months that perfectly illustrate these risks.
Because of investors' hunger for income, many CEFs with high payouts reached staggering premiums this summer only to collapse a few months later. Just three months ago (Aug. 31), 43 CEFs were selling at double-digit premiums, compared with 35 at year-end 2011. While this may not seem all that extreme, only 25 funds were selling at double-digit premiums as of Nov. 30 and the largest-premium fund, PIMCO Global StocksPLUS & Income PGP, saw its premium shrink to 42% from over 85% this summer.
PGP's 85% premium in mid-July was almost unbelievable, likely the result of the nearly 20% distribution rate at net asset value as well as the PIMCO brand name. While the fund's managers had a history of racking up impressive long-term total returns on the underlying portfolio, investors don't receive the NAV returns of a CEF, but rather its share price returns. While the premium dropped only slightly from its mid-July high to 79% at the end of August, over the next three months, PGP's premium continued to fall, dropping to 42% at the end of November. To be sure, the premium is still very high (too high in my opinion) and continues to be the largest premium in the CEF universe. Investors purchasing shares at the end of August lost 13.6% on a share price total return basis (this includes the fund's distributions of $0.45 per share during the three months), while the total return to the NAV was a gain of 10%. That's a 24% difference in share price and NAV return! This experience is not unique to PGP. In fact, nearly all of the funds selling at double-digit premiums three months ago have seen their share prices underperform their NAVs on a total return basis.
This is not to say investors should purchase CEFs trading at wide discounts either. RENN Global Entrepreneurs RCG was selling at the largest discount (35%) on Aug. 31, and, over the past three months, the fund's share price return was a loss of 14.6% (including distributions) and its NAV dropped 2.7%. Of course, investors doing even basic research would have found numerous red flags and flaws in the fund.
These examples are not meant to scare potential investors from CEFs but to warn of a common mistake made by investors new to the space. I've been told many times by individuals that they will never invest in a CEF because they purchased a fund one time and got burned. This too, is a mistake. CEFs have many positive features outside of high payouts, including access to hard-to-reach strategies, asset classes, and securities; the ability to leverage assets, boosting total return potential; and the opportunity for investors to take advantage of the movements in market prices that are unrelated to the underlying holdings and more connected to market sentiment.
Ultimately, investing involves risk. Any investment can lose money. But why increase those chances by purchasing shares at super-premium pricing? Understanding the risks of CEFs and avoiding the trap of chasing performance or distributions is essential to reaping the rewards of this quirky, yet potentially profitable, investment vehicle.
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