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Year in Review: Equity-Focused CEFs

Most equity-focused CEFs posted truly spectacular total returns in 2012, but there were a few exceptions.

Mike Taggart, CFA, 01/04/2013

Every year around the holiday season, I like to take some time to look back over the preceding 12 months to take stock of events. It's also a good opportunity to go over the portfolio and make tweaks where needed. With all the doom and gloom that surrounded the Fiscal Cliff talks heading into the final months of 2012, it was easy to lose sight of the fact that it was a rather good year in the markets, despite the fourth quarter. In fact, for the year, every closed-end fund group (with one exception) posted a double-digit total return on both a net asset value and share price basis. Commodities-focused CEFs proved the exception, posting an average 5.26% NAV total return and an average 2.55% share price total return.

There is much to be written about the past 12 months, and the specifics of various asset classes vary widely. In fact, one article would be too long to incorporate even the highlights of 2012 for CEFs. Therefore, this year we've split the annual review into parts. This week, I'll look at equity-focused CEFs. Next week, Morningstar Analyst Cara Esser will go over the taxable fixed-income CEFs. On Jan. 18, Morningstar Analyst Steven Pikelny will review the tax-exempt municipal CEFs. In a Tuesday article on Jan. 15, I'll take up the allocation and commodity CEFs.

Total Return Performance
Within equity-focused CEFs, we look at those with broad United States equity exposure, those with a sector focus (be it U.S. or global), and those with a global and foreign emphasis.

Broad U.S. equity CEFs performed well for the year, though as the table below shows, investors on average sold the funds in the fourth quarter. The average U.S. equity CEF posted a 12.25% NAV total return and a 14.79% share price total return for the year. Such performance was easy to overlook given the sketchy performance at year's end. The best average performance on a NAV basis (15.65%) came from small-cap CEFs. There are two funds in that segment: Royce Value Trust RVT, which carries a Gold Morningstar Analyst Rating, had a total return of 14.7%, while Royce Micro Cap Trust RMT delivered a total return of 16.6%. On a share price total return basis, it was the large-blend average of 16.4% that came out on top. There are 22 funds in that segment, and Gabelli MultiMedia GGT led the way with a 21.7% NAV total return and a 40.6% share price total return.

Within the sector-equity funds, the villains of the 2008 financial crisis had another banner year while the hot sector of the past couple of years fell behind in the final quarter. Real estate-focused CEFs posted an average 24.6% NAV total return and 32.0% share price total return during the year. Alpine Global Premier Property AWP, which has a Morningstar Analyst Rating of Neutral, led the sector on both measures, delivering a 36.5% NAV total return and a 50.4% share price total return. CEFs focused on financial equities also performed strongly, with an average 23.3% NAV total return and 36.7% share price total return. All three funds in this sector (JH Financial Opportunities BTO, First Trust Specialty Finance FGB, and DH Financial Trends DHFT) performed exceedingly well. The strong performances of the real estate and financial CEFs in 2012 boosted their long-term total returns, all but erasing the average annualized losses over the last five years. In fact, of the two sectors, only three funds still have negative annualized five-year share price total returns: Neuberger Berman Real Estate Securities NRO is still down 4.6%, DH Financial Trends has lost 1.5% annualized over the past half decade, and Alpine Global Premier Property is still off 0.1% despite its phenomenal 2012.

It would be improper to overlook the average NAV total return of 23.5% and share price total return of 31.3% that the health sector CEFs posted. All four funds did well in the year.

Relatively middling performance came from the MLP-focused and natural resource-focused CEFs. Both segments have been relatively hot over the past several years. Perhaps the underlying markets are becoming overly saturated with capital. MLP-focused CEFs in particular have seen new share issuances in the form of both initial public offerings and secondary offerings. However, the performance on an NAV basis in 2012 was lackluster at best and likely disappointing to investors who have bought into the latest offerings. While the underlying story of shale natural gas development in the U.S. remains compelling, it remains to be seen if the economics pan out as they historically have.

Even with the great performance of the U.S. and sector CEFs, it could be argued that the global and foreign equity CEFs had an even better year. The group as a whole averaged 19.6% in NAV total returns and 22.0% in share price total returns. Latin American equity funds led the group, thanks in large measure to the two Mexico-focused CEFs: Mexico Equity & Income's MXE total returns were 47.1% at NAV and 45.1% on the share price; Mexico Fund MXF total returns were 37.8% at NAV and 42.2% on the share price. For those investors brave enough to ignore the headlines and venture into European-equity CEFs at the end of 2011--well done! The average European-equity focused CEF posted a 23.4% NAV total return and a 24.4% share price total return. Two funds stand out in this segment: Turkish Investment Fund TKF had a 54.4% NAV total return, which is shocking given all that's been going on in that part of the world (economic ruin to the west, civil war to the south), and New Germany Fund GF had a 30.4% NAV total return.

Surely, Massive Leverage Must Have Helped Equity CEFs Post Such Great Returns

Given the great performance of equity-focused CEFs in 2012, it is tempting to attribute much to leverage. After all, in rising markets with exceptionally low interest rates, we find leverage to be at its best. But as the table above shows, there are limits. And as the tables below show, the best performance within each group came not from the funds with the highest leverage but from those somewhere in the middle. While it's true that this table only takes into account total leverage ratios as of the end of December, having looked at the table for years now, the trend typically holds true month after month. The equity-focused CEFs with the highest leverage rarely post the highest total returns, though that isn't true for taxable or municipal fixed-income CEFs. This is no surprise, as leverage only magnifies returns--it doesn't improve portfolio manager decision-making. Equities, which are more volatile than fixed-income securities generally, seem to be more prone to the vicissitudes of leverage. The table shows that the leverage sweet spot for equity CEFs is somewhere south of 50%, likely much closer to 20%.

Individual CEF Performance
The tables below reflect much of what has already been discussed. The exceptional year that U.S. and global and foreign equity CEFs had is exemplified by their worst performers: only one fund in each group posted a negative total return (First Trust Active Dividend Income FAV and Japan Smaller Capitalization JOF). As for leverage, an entire article could be written focused only on these tables. For instance, when it comes to U.S. equity funds, all five of the best performers are leveraged, whereas four of the five worst performers have no leverage, which likely hindered their performance. The fifth-worst performer used what I consider excessive leverage, delivering a positive total return but to little avail.

The performance of the Thai Fund TTF was truly impressive, and we could write articles on every fund on the list, but I want to focus on just two. First, Gabelli Equity Trust GAB appears on the table due to its 19.2% NAV total return, and it was also the fifth-best-performing U.S. equity CEF on a share price total return basis (23.8%). This fund is one of only five CEFs that carry a Morningstar Analyst Rating of Gold (another being Royce Value Trust, mentioned previously). As I state in my Analyst Report, "Mario Gabelli can be a polarizing figure. He has been derided as a marketer and his funds have been said to be too expensive. He has been hailed as an investment guru, and his funds have been held up as a testimony to the superiority of value investing. Gabelli Equity Trust stands as a testament to the second view." I especially highlight this fund due to the amount of email I received when the rating was launched. Although the ratings are meant to assess performance over a five-year time frame, it would seem this one is off to a very good start. A look at the fund's holdings is very telling. Only two of the top 20 holdings posted negative returns in 2012. The top performer, which is only 0.5% of the portfolio as Gabelli is trimming exposure, was Ryman Hospitality Properties RHP (formerly Gaylord Entertainment), which rose 83.9%. The worst performer, Newmont Mining NEM, lost 24.3% and is now only 0.62 of the portfolio.

Newmont Mining is indicative of the horrid year that global mining firms had, and this is reflected in the performance of ASA Gold and Precious Metals ASA. This fund put up the worst-performing total return figures on both NAV and share price bases of any CEF. That the fund's largest holding (10.6% of the portfolio), Barrick Gold ABX, lost 27.6% in 2012 is hardly reassuring. The fund carries a Morningstar Analyst Rating of Bronze, which does not appear to be working very well. However, these ratings are meant to look at risk-adjusted returns relative to the category (here, equity precious metals) average for CEFs, mutual funds, and ETFs. For the year, the average ETF in the category posted a 0.8% gain, while the average mutual fund had a 9.2% loss. ASA clearly lost ground, but it's not out of the game yet and my rating still stands, though I continue to watch for any signs of further underperformance.

Even with the concerns about the Fiscal Cliff in the U.S., more broadly the fiscal debt concerns in the developed world, and uncertainty about global macroeconomic conditions, 2012 turned out to be a great year for equity-focused CEFs. Let's hope similar things can be said for 2013.

Click here for data and commentary on individual closed-end funds.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.

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