CEF Weekly Review: CEF Fees Remain Full Of Pitfalls

Welcome to another installment of our CEF Market Weekly Review, where we discuss closed-end fund (CEF) market activity from both the bottom-up – highlighting individual fund news and events – as well as the top-down – providing an overview of the broader market. We also try to provide some historical context as well as the relevant themes that look to be driving markets or that investors ought to be mindful of.

This update covers the period through the second week of February. Be sure to check out our other weekly updates covering the business development company (BDC) as well as the preferreds/baby bond markets for perspectives across the broader income space.

Market Action

CEF price action was mixed this week. Higher-quality fixed-income sectors and interest-rate sensitive equity sectors saw lower NAVs due to the back-up in Treasury yields. Other fixed-income and equity sectors enjoyed the rally in stocks. This also pushed discounts tighter across nearly all CEF sectors on the week. Year-to-date, discounts are tighter across all sectors save for Global Income.

The median sector CEF discount is now not all that far from its average level this century. Strong risk sentiment and a look-through to lower leverage costs have supported CEF valuations.

Market Themes

There was a quick discussion about CEF fees on the service and, specifically, how different sources show different numbers. There are roughly three types of expenses – the management fee, fund-level expenses and leverage costs (another source – acquired fund expenses – tends to be fairly minimal for most funds). Confusingly, they are often combined and referred to holistically. Some sources list just the management fee, others combine the management fee and other sundry expenses, while others sum up the whole shebang. Needless to say, this makes it difficult to gauge the true figure or make comparisons.

Another reason why fee comparisons are hard is because they are often presented based on net assets. This means that funds with the same management fee will look like they have different fees if they have different levels of leverage. A higher-leverage fee will show a higher fee on net assets. This might cause an investor to think that if the two funds held the same portfolio the higher-fee fund would generate less net income. It’s actually the opposite as the higher leverage would in all likelihood more than compensate.

Investors often like to go to the shareholder reports to suss out the actual fee by, say, dividing expenses by net assets. However, this can also be misleading particularly when NAVs move a lot. A management fee is typically accrued on a daily total asset basis so a sharp move in the value of assets will result in a misleading number. The best thing to do is just to see what the fund actually charges – this is usually listed on its website, though it often does not list additional fund expense costs.

Another pitfall is to ignore leverage structure and view leverage costs in a rear-view mirror. Here it’s important to understand how leverage cost will evolve over time based on short-term rates. Any hedges will typically not be reflected in leverage costs which creates another potential pitfall.

Despite all these pitfalls, it’s worth putting in the work as getting a good sense of fees across all components is one way in which investors can generate significant alpha across CEFs.

Market Commentary

There were a modest number of distribution changes announced this month. BlackRock marginally tweaked the distributions of three of their equity CEFs, cutting BMEZ, BIFZ, and hiking BSZ. Recall these 3 had cuts of around a third last year.

Eaton Vance had marginal adjustments for their short-duration CEFs: EVV (down) and EVG (up).

Nuveen hiked the distribution of the Nuveen Variable Rate Preferred & Income Fund (NPFD). Investors familiar with the preferreds market would raise their eyebrows at the “Variable Rate” name given there are not that many variable-rate preferreds in the market now. As it happens, the fund actually only holds about 8.5% of its portfolio in floating-rate securities. It does have 30.5% in Fix/Float securities however some of these may get redeemed. Arguably, the fund should really be called a “Limited Duration Preferred CEF” since its overweight in Fix/Float and reset preferreds leads to a very modest duration of sub-3.

Stance and Takeaways

As a rule of thumb, CEFs with lower fees should trade at tighter discounts, all else equal. This is why we like to allocate to these funds when the market is not pricing them correctly. The best fund from this perspective has historically been the Credit Suisse Asset Management Income Fund (CIK) which has a fee (management fee + sundry expenses) that works out to around 0.58% on total assets – one of the lowest in the CEF space.

Unfortunately, the market has finally caught on to this in the last 18 months or so and the fund has been trading at a steep premium to the sector. Its valuation, however, does collapse occasionally, offering a good entry point.

The Flaherty & Crumrine Preferred Income Opportunity Fund (PFO) has a fee (management fee + sundry expenses) of around 0.88% on total assets which is also on the low side in the broader credit CEF space. This, along with its wide discount and likely decrease in leverage costs later this year, is one reason why we recently allocated to it.