Here’s how to avoid such disasters
Many investors will tell you that the higher the dividend yield of an investment, the greater the risk of experiencing a significant drop in dividends, especially during a market downturn.
To this I have an answer: these people have never invested in closed funds (CEF)!
The portfolio of our CEF insider service is one example. It averages 6.6%, five times the income-hungry S&P 500 crowd, and payments to our funds have held up well throughout this crisis.
As the Eaton Vance Global Dividend Tax Advantage Fund (ETG), which we bought in January 2020, when it returned a handsome 6.7%. Throughout the pandemic, that payout has been strong: Overall, ETG has offered investors a 27% total return compared to those pre-crisis days, most of it in dividends, thanks to its yield to success.
But not all CEFs are winners like ETGs – some bleed your money with disproportionate fees, underperformance and worse – so we need to be careful. Here are three tips you can use to focus on FEC winners and avoid landmines.
CEF Safety Tip # 1: Know When to Change Course
Let’s start by going back to the early 2010s. At the time, you might have heard the argument that High Yield Master Limited Partnerships (MLPs) that operate pipelines cannot lose because they charge fees per. barrel to ship oil and therefore are immune to falling oil prices.
One way to play this angle would have been through a CEF like the ClearBridge MLP and Midstream Fund (CEM), which brings in 6.5% today.
However, like oil prices, the CEM is very volatile, and investors who did not budge when the ‘MLPs don’t care about oil prices’ argument fell flat in 2014 after the collapse oil, went through years of volatility before a worse crash. in 2020, from which the CEM has not yet recovered.
Certainly, buying CEM at its lowest, or when oil is no longer in vogue, is a good way to capture short-term gains, but this strategy is not for the faint of heart. You will need to have strong nerves and be prepared to sell quickly in the event of a market downturn. In other words, this is not a fund to buy and store forever.
CEF Security Tip # 2: If a fund’s strategy can’t be easily explained, drop it
Eagle Point Credit Company (ECC), Paying a 7.1% dividend, would like to tell investors that his portfolio is difficult to understand. And they are right ; this is. ECC invests in Equity Secured Loan Bonds (CLOs), the riskiest part of a group of exotic derivatives that cannot be easily explained in a thousand words, let alone one sentence.
In addition, ECC borrows aggressively and charges high fees (they vary, but have exceeded 10% of assets in the past), in addition to holding a portfolio that is very sensitive to market disruptions.
As ECC shareholders saw their investment plummet by more than 60% in value in the darkest days of the pandemic, a mix of Federal Reserve bailouts and income-hungry investors helped the fund recover. its pre-pandemic levels, although it is still far from underperforming the S&P 500. In the next crisis, the ECC may not be so lucky.
CEF Safety Tip # 3: Adopt leverage up to a point
Now that we’ve covered what to avoid when selecting CEFs, let’s take a look at something to look for. This one may surprise you: leverage.
Certainly, one cause of big declines like the ones you see above is a fund that simply borrows too much money, which amplifies its losses in a plummeting market.
Many investors respond to this by avoiding leverage altogether, but it is a missed opportunity. Imagine refusing to buy a car or a house without taking out a loan! Leverage, when used with caution, can increase returns, especially in a time of record borrowing costs like we are experiencing today. The key is to avoid too much leverage.
But how much is too much? Studies show that in most downturns of the past 20-25% leverage has been perfectly safe, as the Aberdeen Asia-Pacific Income Fund (FAX), an outfit of our companion Contrary income report service, prove.
As of this writing, FAX has a leverage ratio of 25.6% and has shown that a modest amount of borrowing can increase returns without posing a downturn risk (FAX easily bounced back from the market crash. dot-com, the 2008/2009 real estate crash, the 2013 taper tantrum and the COVID-19 crash).
The fund’s leveraged-assisted earnings also help secure its 7.6% dividend, which provides its shareholders with a high and secure stream of income that they can use however they see fit.
Michael Foster is the Senior Research Analyst for Contrary perspectives. For more great income ideas, click here for our latest report “Indestructible Income: 5 windfall funds with secure 7.3% dividends.“