Vector illustration of business people on a roller coaster bar chart
When I explain the appeal of closed-end funds (CEFs), I usually start with the big headline and then throw in a few points after that, like this:
CEFs yield an average of 8%, and many of these dividends are sustainable and growing.
- CEFs invest in a variety of reliable and popular assets such as stocks, bonds and real estate investment trusts (REITs).
- CEFs often trade at discounts to the value of their portfolios. This is called a discount to net asset value (NAV) and means that through CEFs we can buy stocks, bonds and real estate for less than we would pay on the open market.
- Many CEFs meet or exceed their benchmarks, with some of them leading the S&P 500 for a decade or more.
And when you start to really delve into the CEF universe, you see even more possibilities. Let’s take this for example Cohen & Steers Quality Income Realty Fund (RQI)which invests primarily in REITs and achieves a return of 8.6%.
I’ve kept a close eye on RQI for years, and it stands out for the stability of its discount, which is currently around 6% and usually hovers around that level – except when, strangely, it hit a big premium in 2019.
This is a good example of how we can use CEF discounts to position ourselves for profits. I first highlighted RQI’s value in a weekly article on our Contrarian Outlook website in November 2017, thanks to its judicious use of leverage at a time of rising interest rates (sound familiar?).
Over the next two years, its market price exceeded that of the S&P 500, as shown below using the index’s performance SPDR S&P 500 ETF Trust (SPY)– in purple – and the REIT index, which SPDR Dow Jones REIT ETF (RWR)—in blue – a more appropriate benchmark as RQI focuses on real estate.
Of course, not all of these gains came at once. As you can see above, RQI really took off in mid-2019 when the discount started to narrow. That’s why I brought it back to readers’ attention in February of that year and reiterated its outperformance potential.
February 2019 is a good reference point for our example, as RQI’s discount quickly faded thereafter, rising to a premium of up to 5% in late September before falling back to the usual level of around 6% in early January 2020. You can see corresponding increases and decreases in fund returns, below in orange.
This long period of outperformance was a clear sell signal that really opened up in June and remained open for a full seven months. Furthermore, the sell signal at the time was made even clearer by the contrast between RQI’s market price-based return and its declining discount, as you can see in this chart:
RQI total return + discount NAV ratio
RQI’s discount remains around 6% or 7% over the long term, but increasing demand for REITs and real estate in 2019 (in response to the oversold market in 2018) was a big opportunity.
But as more people became aware of this market inefficiency, the RQI discount morphed into this 5 percent markup – something not seen since the Great Recession of 2007-2009.
This highly unusual shift was a clear sell signal and highlights the power of the CEF discounts determining our entries and exits into these funds.
This CEFs swing trade opportunity is true magic because if you’re wrong, you’re wrong Despite it get paid all the time. RQI paid an 8% dividend in February 2019, and the yield is now 8.6%. So even if you missed the sell signal, you still got a huge source of income along the way.
Similar opportunities currently exist across the CEF space, particularly in equity funds.
Equity CEFs Flat 2023
As our CEF Insider Equity sub-index shows, equity CEFs (most of which hold S&P 500 stocks) are up just 0.1% year-to-date, while the S&P 500 is up 14.5%.
That makes no sense.
One of the strangest examples of this separation is perhaps this Nuveen S&P Dynamic Overwrite Fund (SPXX)which has delivered a strong return on a NAV basis this year as the fund owns the entire S&P 500. But for some reason CEF investors sold it, which is why the fund’s market price is actually down year to date!
To illustrate this point, let’s look at SPXX on Google Finance, which shows us the decline on a price basis only (as opposed to total returns in the chart above). See how much the company has fallen year to date despite owning S&P 500 stocks And Earns additional income by selling covered call options on your portfolio?
SPXX since the beginning of the year
The result is a 9% discount on the net asset value – for a fund with an average of a 1.9% premium in the last 52 weeks!
For lateral thinkers who like to buy cheaply while others want to sell, a fund like SPXX is an attractive option. The company has a strong portfolio, a solid strategy and a dividend yield of 8.1%. It shouldn’t fall while the value of its portfolio rises!
By the way, this doesn’t just happen with SPXX. Literally hundreds of CEFs are ripe for a swing trade like RQI in 2019: This is a market where still-cautious (and therefore largely sidelined) retail investors have given us the opportunity to earn cheap returns. Do not miss that.
Michael Foster is the senior research analyst for Contrasting outlook. For more great income ideas, click here for our latest report “Indestructible income: 5 cheap funds with a stable 10.2% dividend.”
Source : www.forbes.com