A rising equity market boosted certain CEFs in the first quarter of 2013.
Despite continued uncertainty in much of the eurozone and what seems like endless political gridlock in Washington, investors should be pleased with overall performance during the first quarter of 2013. So far, volatility levels have remained relatively low and major stock market indexes have recorded steady gains. (The S&P 500 Index gained nearly 11%, the NASDAQ 100 gained almost 12%, and MSCI World returned just under 8%.) All is not rosy, of course, with the Barclays U.S. Aggregate Bond Index essentially flat for the year and slower growth in some previously thriving emerging-markets economies. Fears of inflation remain top of mind for many fixed-income investors, as no one can reliably predict the long-term consequences of sustained low interest rates. Nevertheless, the stock market has been chugging along, relieving fears (temporarily at least) of the United States' own version of Japan's lost decade.
Closed-end funds, or CEFs, especially equity sector-focused funds, have benefited from the strong start to the year. Of the 594 funds with at least three months of returns, only 88 (or 14%) posted negative net asset value returns during the first quarter. We’ve seen a slight reversal in performance trends as the average equity CEF outperformed both taxable fixed-income and municipal CEFs (up 8% versus 3% and 0.6%, respectively) so far this year. Municipal CEFs had a strong runup over the past two years, but as some funds reached relatively high premiums, investors began backing off. Similar to 2012, share prices have not tracked NAV returns for the group very closely as the average muni CEF saw its share price decline by 0.5% in the first quarter, narrowing premiums and widening discounts. Equity CEFs, on the other hand, have seen some discount narrowing and premium widening as the average share price gain outpaced NAV performance by 2 percentage points.
Initial Public Offerings
Despite the stronger movement in the equity market, fixed-income CEFs remained a hot commodity in the IPO market. The most notable launch of the first quarter was PIMCO’s second go-anywhere bond fund PIMCO Dynamic Credit Income PCI. The fund grossed nearly 3 times the assets as its sister fund, PIMCO Dynamic Income PDI, which was launched last year. It was also the largest IPO since 2007. During the past two calendar years, a wealth of MLP, infrastructure, and energy funds were launched, and this year is shaping up to be another big year. Two of the eight IPOs this year are MLPs, five are fixed-income funds, and one is a real estate fund. The table below lists the five IPOs of 2013, their Morningstar Category, the IPO date, proceeds, and the current premium at which the funds sell.
Best and Worst Performers
While the overall market has done well this year, none of the best- or worst-performing Morningstar CEF categories (based on NAV returns) is a broad market strategy such as large-cap domestic stocks or U.S. corporate bonds. Interestingly, only one fixed-income category (emerging-markets bond) makes either the top- or bottom-performers list. The table below lists the top-performing CEF Categories for the year to date with NAV and share price performance data.
The best-performing category for the year to date was equity energy, which is mostly composed of MLP funds. This group came roaring back in the first quarter after being among the worst-performing categories during calendar 2012. Benefiting from the Affordable Care Act, health-care and related CEFs did quite well in the first quarter with a category average gain of 14% based on NAV and 16% on share price. These funds' premiums have been widening and discounts narrowing fairly steadily over the past three years, as the average share price gain of 23% outpaced the average NAV gain of 18%. Among the worst-performing categories is emerging-markets bond, a category that had done well as investors looked outside of the U.S. for growth and income. After a relatively strong three-year run, the emerging-markets debt category has slowed its course, but investors are not backing off. The category average share price gain for the first quarter was 1.45%, higher than the average NAV loss of nearly 1.0%.
The best- and worst-performing individual CEFs based on NAV track fairly closely to the category averages, with a few outliers. Not surprisingly, each of the top-five best-performing funds falls into the equity energy category, and all are MLP funds. Despite middling returns in 2012, these funds have performed exceedingly well in 2013 so far. Among the worst-performing funds, we see the impact of changing views on inflation in the volatility of returns. Some investors who sought shelter in gold and precious metals abandoned these funds as the stock market picked up, causing share price returns to fluctuate greatly. ASA Gold and Precious Metals
Distributions and Discounts
As of the end of March, the average equity CEF was trading at a 1% discount, much narrower than the average discount of nearly 7% at the close of 2012. Taxable fixed-income funds have experienced widening discounts from an average of less than 1% at year-end to nearly 4% at the quarter-end. Municipal CEFs are still, on average, selling at premiums, but the average premium has narrowed in the first quarter to less than 1% currently from 2.5% at year-end. Broadly speaking, fund distributions have continued to fall, with nearly 2.5 times more reductions than increases so far this year. For the nearly 100 funds changing distribution rates this year, the average distribution was cut by 7.5%.
Overall, CEFs have performed admirably in the first quarter of 2013, with some sectors and funds benefiting more than others. It’s always important to remember that investing in an actively managed fund means investing in a manager. While a sector or region may be “hot” fund managers may be “hot” by proxy, benefiting from a rising tide that lifts all boats. For example, MLP fund Crushing Royalty & Income SRF gained just 5% for the year to date, underperforming its peer average by nearly 12 percentage points. Morningstar provides a rating on more than 120 CEFs using our Morningstar Analyst Rating for Funds. The rating includes a detailed discussion of the investment process and the management team to help investors determine whether a fund may be appropriate for inclusion in an investor’s portfolio.