My apologies to readers. My hosting company’s server went down, and lost the first version of this post. Here’s a second try.
A friend alerted us to some closed-end funds trading at meaningful discounts to NAV. For example, Eaton Vance Tax-Managed Global Diversified Equity Income (EXG). is trading at a 15% discount. This fund owns mega-cap stocks from developed countries, and has 52% of its portfolio in non-US stocks, especially European behemoths that generate signifcant chunks of their revenue outside of Europe. Stocks such as Royal Dutch Shell, Nestle, Novartis, and Siemens are prominent holdings.
The fund also uses a call-writing strategy to generate income. This limits its upside because buyers of the calls can purchase stocks away from the fund at a prearranged price if stock prices rise, but it serves to generate a healthy yield on top of the dividends these stocks are paying.
The fund’s discount to NAV means investors are getting considerable exposure to arguably already-cheap European dividend-paying stocks at a further discount, while the call-writing strategy provides an additinoal income kicker.
Now it’s not always easy to understand how a closed-end fund trading at a discount to NAV can narrow the spread between its trading price and NAV. However, this fund is paying out capital to investors as part of its distribution. Although Morningstar doesn’t think this is a good idea, we think it may be good for investors. Here’s what Morningstar says about closed-end funds paying out capital:
Second, executives could be purposefully setting distributions at unsustainable levels. Fund executives realize that a CEF’s distribution rate correlates highly with the share price investors are willing to pay. In fact, CEF distribution rates correlate highly with premiums.
One executive at a fund that we are not too keen on actually wrote that he found our use of the term “destructive” to be “frankly offensive.” He argued that by returning destructive capital to the CEF’s shareholders, the CEF had gone from a 15% discount to an 8% discount.
Do not let such argument fool you into putting your money into CEFs that primarily use destructive return of capital to meet their unsustainable distribution levels. Total return is all that matters.
We’re not so sure Morningstar is completely correct about this. We won’t speculate on what the fund’s motives for paying out capital are, but an investor is currently buying this fund’s assets at $0.85 on $1.00., while the fund’s return of capital represents a return of $1.00. If the fund were to liquidate entirely in one fell swoop, and return all investor capital, it seems investors would realize an immediate 17.6% gain. Returning capital closes the spread between the share price and NAV. Perhaps investors in closed-end funds trading at discounts should want the funds to return their capital as a means of reducing the spread or gap between the market price of shares and NAV.
Still, despite our argument, Morningstar may have a point. In practice, our friend notes it’s sometimes true that closed-end funds paying capital back wind up cutting the dividend or doing a rights offering, either of which further increases the discount. Therefore, he has mentioned that EXG’s sibling, ETJ, may be a better option since it has cut its dividend already.
ETJ has a more complicated options strategy than EXG, however. Moreover, it appears as if EXG reduced it’s dividend as well in both 2010 and 2011 (though it may certainly do it again). And the threat of a dividend cut or rights offering hasn’t prevented a successful mutual fund, River North Core Opportunity (RNCOX), from making EXG it’s top holding.
Equity investors seeking income via exposure to mega-cap global firms, including those based in Europe, at a discount should take a look at both funds. Again, the options strategies will limit upside, but the juicy yield and price discounts give these funds some appeal.
