GAM CEF: A Robust Way To Extract Equity Dividends In A Low VIX Environment (NYSE:GAM)

Thesis

General American Investors (GAM) is an equity CEF. We have covered this name before here, when we assigned it a ‘Hold’ rating based on its intrinsic characteristics. We are revisiting this name based on a very interesting development in the market this past year: most equity CEFs tracking the S&P 500 have managed to underperform, mainly due to their options utilization in extracting dividends from their portfolios. Options utilization references the writing of covered calls on the underlying equities, strategy which has backfired on the back of a very low VIX environment and realized volatility higher than implied for certain periods of time.

GAM on the other hand represents an ‘old-school’ equity CEF which has a fairly low dividend yield of 6.2% (by CEF standards), but does not use covered calls, and has thus been able to fully match the index in the past year:

In this article we are going to outline the positive structural features which make GAM an attractive equity CEF in today’s environment, and walk readers through the reasoning behind the rating upgrade to ‘Buy’.

2023 was a disappointing year for many equity CEFs

If we look back in the past 12 months we can see a very troubling trend in the equity CEF space:

The vast majority of CEFs in the above graph have underperformed the S&P 500. Some funds have had a middle of the road performance such as the pure ‘Buy-Write’ Eaton Vance Tax-Managed Buy-Write Opportunities Fund (ETV) while others such as Madison Covered Call and Equity Strategy Fund (MCN) were flat. Even classic equity CEFs such as the Enhanced Capital and Income Fund (CII) which overwrites just 50% of the notional had a poor year. The reason for this performance is the structural CEF feature dealing with dividend extraction.

Many ‘classic’ equity CEFs have started using covered calls on roughly half of their portfolios as a method of dividend extraction. By writing calls CEFs are selling shares at slightly higher prices or pocketing the premiums, depending on what the market does. This method works best in a normal or high volatility environment. However, the past year has seen a severe suppression of volatility as measured by the VIX index:

In a normalized environment the VIX bounces around the 20 mark level, while aggressive bull markets see it at today’s levels. Risk-off events push the index above 30. That was the story that unfolded during 2022, when bouts of risk-aversion saw the index breach the 30 mark, and then performing a mean-reversion to the low 20s. It has been a downhill move in the VIX ever since December 2022.

GAM does it the right way

GAM does not utilize options, and its portfolio build uses capital appreciation and outright equity selling to generate the dividends to be distributed. This methodology has allowed the fund to match the index in the past year. As a retail investor you need to keep in mind that even if you think the GAM dividend yield is too low, you can always sell a small portion at the end of the year to generate the annual cash flow you were looking for.

The CEF’s current analytics are:

• AUM: $1.0 billion.
• Sharpe Ratio: 0.46 (3Y).
• Std. Deviation: 16.5 (3Y).
• Yield: 6.2%.
• Premium/Discount to NAV: -18.4%.
• Z-Stat: -1.32.
• Leverage Ratio: 14%.

As we can see from the above figures, the yield is only 6.2%, a bit short of the 8% to 9% offered by the ‘traditional’ equity CEFs. Again, a retail investor can always supplement the all-in yield at the end of the year by selling a small portion of the holding. In this fashion they would have realized both a 20% plus total return, and the required dividend yield for the year of around 8%.

This structural feature will remain paramount as long as VIX is low. GAM will continue to perform based on its underlying portfolio rather than also be dependent on volatility levels and realized versus implied volatility.

Fund composition

The fund focuses on a bottom up approach with a small portfolio of what it perceives to be the strongest companies to proxy the index performance. As of the latest Semi-Annual report, the CEF held 66 names, with IT as the largest sectoral allocation:

Information Technology is followed by Financials and Consumer Discretionary as the next two sectors in the fund. This constrained approach has worked throughout time. This CEF is not known for stellar outperformance, but for a reliable, transparent, constant performance.

Discount to NAV – do not have any expectations here

The CEF has always traded at significant discounts to NAV:

We can see a tight range here around the -16% discount to NAV mark. As a retail investor you should not expect any gains from the narrowing of the discount. The fund is a ‘boring’ one that will not suddenly change its mandate and will just keep plugging along.

Conclusion

GAM is an equity closed end fund. Reliable and boring come to mind when talking about this CEF, but these elements do come in handy at times. And today’s environment is one of those times. With a low VIX level, many equity CEFs have seen their performance versus the S&P 500 slip significantly due to their propensity to extract dividends via writing covered calls. The past year has seen market moves exceed the implied volatility in the premium received, which has caused the CEFs to underperform. GAM extracts dividends the ‘old school’ way by simply selling exposures. The fund does not have the pressure faced by other CEFs given its annual dividend policy and low 6.2% yield. However the CEF delivers. As long as the VIX continues to stay very low, GAM is the better alternative over equity CEFs which utilize covered-call strategies. We are therefore of the opinion GAM is a buy versus its peers which embed a secondary risk factor, namely implied volatility.