5 Best CEFs To Buy For September 2019

For income investors, closed-end funds are an attractive investment Class that covers a variety of asset classes and promises high distributions and a reasonable total return.

In the CEF world, it\'s hard to figure out which funds to buy and when to buy.

In this monthly series, we highlight five CEFs that have a solid track record, pay high distributions, and are offering \"excess\" discounts.

We try to separate the wheat from the chaff using our filtering process to select just five CEFs from around 500 closed-end funds.

For income investors, closed-end funds, or CEFs, are an attractive investment class that offers high income generally in the range of 6%-10%, broad diversification in terms of a variety of asset classes, and market matching total returns in the long term if selected carefully.

However, CEFs come with their own set of risks and challenges that investors should be aware of. We list various risk factors at the end of this article.

The year 2019 has been quite volatile for the stocks thus far. From the panic of May and early June, markets had bounced back strongly in July, only to see some weakness in August because of the trade issues coming to the forefront. In spite of the trade frictions and global economic slowdown, markets have shown a lot of resilience and stand just a hair below their all-time highs.

During this volatile ride, one type of investment (iclosed-end funds) has not only survived but has excelled the overall market. CEF funds generally have done very well this year, for instance, our "8% CEF Income" portfolio is up 23.6% year-to-date. However, this also means that most CEF funds are not cheap today. But at the same time, as income investors, we cannot afford to be cash heavy and need to be always on the lookout for good investment candidates which have a solid track record, offer good yield and are attractively priced.

For regular stocks, there are several popular metrics that we could use to figure out if the stock was overvalued or undervalued at a given time, though it's not easy. But it's even harder to figure out which CEF funds to invest in and if they are attractive buys at a given point in time. This is what this series of articles does - to attempt to separate the wheat from the chaff by applying a broad-based screening process followed by an eight-criteria weighting system.

This is our monthly series on CEFs, where we highlight five CEFs that are relatively cheap, offer "excess" discounts to their NAVs, pay high distributions, and have a solid track record. We also write a monthly series to identify "5 Safe and Cheap DGI" stocks. You can read our most recent such articlehere.

We use our multi-step filtering process to select just five CEFs from around 500 available funds. The selected five CEFs this month, as a group, are offering an average distribution rate of 7.52% and provide an average discount/premium of -4.66%. In addition, these five funds have collectively returned 8.32% since inception (over 10 years). Since this is a monthly series, there may be some selections that could overlap from month to month.

Please note that these are not recommendations to buy but should be considered as a starting point for further research.

Our goals are simple and are aligned with most conservative income investors, including retirees those who wish to dabble in CEFs. We want to shortlist five closed-end funds that are relatively cheap, offering good discounts to their NAVs, paying relatively high distributions and have a solid and substantial past track record in maintaining and growing their NAVs. We adopt a systematic approach to filter down the 500-plus funds into a small subset.

Here's a summary of our primary goals:

A well-diversified CEF portfolio should at least consist of 10 CEFs or more, preferably from different asset classes. It's also advisable to build the portfolio over a period rather than invest in one lump sum. If you were to invest in one CEF every month, in a year, you would have a well-diversified CEF portfolio. What we provide here every month is a list of five probable candidates for further research. We think a CEF portfolio can be an important component in the overall portfolio strategy. One should preferably have a DGI portfolio as the foundation, and the CEF portfolio could be used to boost the income level to the desired level. How much should one allocate to CEFs? Each investor needs to answer this question himself/herself based on the personal situation and factors like the size of the portfolio, income needs, risk appetite, or risk tolerance.

We have more than 500 CEF funds to choose from, which come from different asset-classes like equity, preferred stocks, mortgage bonds, government and corporate bonds, energy MLPs, utilities, and municipal income. Just like in other life situations, even though the broader choice always is good, it does make it more difficult to make a final selection. The first thing we want to do is to shorten this list of 500 CEFs to a more manageable subset of around 100 funds. We can apply some criteria to shorten our list, but the criteria need to be broad and loose enough at this stage to keep all the potentially good candidates. Also, the criteria that we build should revolve around our original goals.

Criteria to Shortlist:

After we applied the above criteria this month, we were left with

114

funds in our list, which is still too long to present here or meaningfully select five funds.

To bring down the number of funds to a more manageable number, we will shortlist 10 funds based on each of the following criteria. After that, we will apply certain qualitative criteria on each fund and rank them to select the top five.

Five broad criteria:

Excess Discount/Premium:

We certainly like funds that are offering large discounts (not premiums) to their NAVs. But sometimes, we may consider paying near zero or a small premium if the fund is great otherwise. So, what's important is to see the "excess discount/premium" and may not be the absolute value. We want to see the discount (or premium) on a relative basis to their record say 52-week average.

By subtracting the 52-week average discount/premium from the current discount/premium will give us the excess discount/premium. For example, if the fund has the current discount of -5%, but the 52-week average was +1.5% (premium), the excess discount/premium would be -6.5%.

Excess Discount/Premium = Current Discount/Premium (Minus) 52-Wk Avg. Discount/ Premium

So, what's the difference between the 12-month Z-score and this measurement of Excess Discount/Premium? The two measurements are quite similar, maybe with a subtle difference. The 12-month Z-score would indicate how expensive (or cheap) the CEF is in comparison to the 12 months. Z-score also takes into account the standard deviation of the discount/premium. Our measurement (excess discount/premium) compares the current valuation with the last 12-month average.

We sort our list (of 114 funds) on the excess discount/premium in descending order. For this criterion, the lower the value, the better it is. So, we select the top 10 funds (most negative values) from this sorted list.

(All data as of 09/16/2019)

High Current Distribution Rate:

After all, most investors invest in CEF funds for their juicy distributions. We sort our list (of 114 funds) on current distribution rate and select the top 10 funds from this sorted list.

Long term Return on NAV (since inception, over ten years)

We then sort our list (of 114 funds) on the Return on NAV (since Inception) and select the top 10 funds.

Medium Term Return on NAV (last 5-years)

We then sort our list (of 114 funds) on the Return on NAV (last five years) and select the top 10 funds.

Coverage Ratio (Earnings vs. distributions)

We then sort our list (of 114 funds) on the coverage ratio and select the top 10 funds. The coverage ratio is derived by dividing the earnings per share by distribution amount for a specific period.

Now, we have 50 funds in total from the above selections. We will see if there are any duplicates.

In our current list of 50 funds, there were 12 duplicates, meaning there are funds that are appearing more than once. So, once we remove the duplicate rows, we are left with 38 funds. We also remove the fund 'CAF' from the list due to very inconsistent dividend history, leaving us 37 funds.

In our list of funds, we already have some of the best probable candidates. However, so far, they have been selected based on one single criterion that each of them may be good at. That’s not nearly enough. So, we will apply a combination of criteria by applying weights to six factors and filter out the best ones.

We will apply weights to each of the EIGHT criteria:

Once we have calculated the weights, we combine them to calculate an “Overall Total Weight.” The sorted list of 37 funds on the “combined total weight” is presented below.

The Selection of Final Five:

Now, we will consider the top 20 names for consideration to select our top five. For this, we will keep the first 20 names based on overall quality (Total-Weight) and ignore the rest.

If we only want to look at overall quality (sorted on the total-weight), we could select the first five names from the above list.

Top Five Quality Rankings:

However, we recognize that these five may be the best based on overall quality but may not be the cheapest (most discount) or cover their distributions fully (100% or more) or may not have the highest distribution rate. So, we will also provide the top five based on each of these criteria, but they also must be in the top 20 based on quality.

Top Five Cheapest funds (most discount):

Top Five – 100% Coverage

Top Five – High Distribution

Top 5 – Highest NAV Return Since Inception (more than ten years)

Now, if we had only five slots for investment and need to select just five funds, we can choose one top fund from each of the five tables (one from each criterion). This step can be subjective and may differ from person to person.

Here are the selections for this month, based on our perspective:

It goes without saying that CEFs, in general, have some additional risks that the investor needs to be aware of.

Leverage and high fees:

They generally use some amount of leverage, which adds to the risk. The leverage can be hugely beneficial in good times but can be detrimental during tough times. The leverage also causes higher fees because of the interest expense in addition to the baseline expense. In the tables above, we have used the baseline expense only. If a fund is using significant leverage, we want to make sure that the leverage is used effectively by the management team - the best way to know this is to look at the long-term returns on the NAV. NAV is the “Net Asset Value” of the fund after counting all expenses and after paying the distributions. So, if a fund is paying high distributions and maintaining or growing its NAV over time, it should bode well for its investors.

Volatility:

Due to leverage, the market prices of CEFs can be more volatile as they can go from premium pricing to discount pricing (and vice versa) in a relatively short period. Especially during corrections, the market prices can drop much faster than the NAV (the underlying assets). Investors who do not have an appetite for higher volatility should generally stay away from CEFs or at least avoid the leveraged CEFs.

Premium over NAVs:

CEFs have market prices which are different from their NAVs (Net Asset Values). They can trade either at discounts or at premiums to their NAVs. Generally, we should stay away from paying any significant premiums over the NAV prices unless there are some very compelling reasons.

Asset-specific risk:

Another risk factor may come from asset concentration risk. Many funds may hold similar underlying assets. However, this is easy to mitigate by diversifying into different types of CEFs ranging from equity, equity covered calls, preferred stocks, mortgage bonds, government and corporate bonds, energy MLPs, utilities, and municipal income.

The underlying purpose of this exercise is to find five likely best funds for investment each month using the screening process. We demand our selections have a solid long-term record, maintain good earnings to distribution coverage, offer high distributions, and are relatively cheaper and offer a reasonable discount. Also, we ensure that the selected five funds form a diverse group. Please note that these selections are dynamic in nature and can change from month-to-month (or even week-to-week). However, some of the funds can repeat from month-to-month if they remain attractive over an extended period.

The selected five CEFs this month, as a group, are offering an average distribution rate of 7.52% and an average discount/premium of -4.66%. In addition, these five funds have collectively returned 8.32% since inception (over 10 years). CEFs, in general, have had a good year thus far, and everything is a bit pricey. Our selections offer an average yield that's slightly lower than we wish for, and the discount is less than we expect, but we believe this is the cost of quality.

We believe that the above group of CEFs makes an excellent watch list for further research.

I am/we are long ABT, ABBV, JNJ, PFE, NVS, NVO, CL, CLX, GIS, UL, NSRGY, PG, KHC, ADM, MO, PM, BUD, KO, PEP, D, DEA, DEO, ENB, MCD, BAC, PRU, UPS, WMT, WBA, CVS, LOW, AAPL, IBM, CSCO, MSFT, INTC, T, VZ, VOD, CVX, XOM, VLO, ABB, ITW, MMM, LMT, LYB, HCP, HTA, O, OHI, VTR, NNN, STAG, WPC, MAIN, NLY, ARCC, DNP, GOF, PCI, PDI, PFF, RFI, RNP, STK, UTF, EVT, FFC, HQH, KYN, NMZ, NBB, IIF, CHI, JPS, TLT.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure:

Disclaimer: The information presented in this article is for informational purposes only and in no way should be construed as financial advice or recommendation to buy or sell any stock. Please always do further research and do your own due diligence before making any investments. Every effort has been made to present the data/information accurately; however, the author does not claim 100% accuracy. Any stock portfolio or strategy presented here is only for demonstration purposes.