2016 CLOSED-END FUND MARKET REVIEW
After getting off to a horrid start in 2016, closed-end funds (CEFs) finished the year with solid gains across nearly all strategies except municipal bonds. Senior loan funds led the way in 2016 as investors flocked in droves to the previously forgotten strategy. A combination of interest rates bottoming in July and the LIBOR rate starting to steadily rise into year-end saw investors rush back into senior loan funds, causing the most discount narrowing of the CEF strategies we track. Specialized equity strategies provided the best performance at net asset value (NAV) in 2016 but saw little discount narrowing as investors continued to shun all equity CEF strategies. Equity funds exhibited minimal discount narrowing in 2016, starting the year with an average discount of -9.28% and ending the year at -8.98%.
In our third quarter commentary, we stated that half of fixed income CEFs were uninvestable due to narrow discounts, the rising cost of leverage, flat yield curve, expected dividend cuts, and narrow fund strategies. Our main focus was on municipal CEFs which had solid gains for the first nine months of 2016 before dropping 9.29% in the fourth quarter to finish the year with paltry gains of 0.65%. The evidence was there for CEF investors to see, yet many still got caught holding the bag. We did not expect a major selloff to come to fruition as quickly as it did but the surprise election of Donald Trump to President along with Republicans retaining the House and Senate caught municipal investors off guard. Rates rose sharply as the market priced in pro-growth policies unencumbered by gridlock from Congress which should lead to stronger GDP growth and higher inflation. Long duration CEFs that utilize leverage continue to be susceptible to more pain as Fed is guiding three rate hikes in 2017. Although the Fed has been overzealous in the past with their rate hike guidance, the market is pricing in two hikes for the year, which will increase the cost of leverage for funds that use floating rate leverage.
For the fourth quarter, the Fund (Class A at NAV) returned 1.47%, outperforming the 0.48% decline of the composite benchmark, by 1.95 percentage points. At quarter-end, the average weighted discount of the CEF holdings in the portfolio was -12.94% versus -12.49% at the end of the prior quarter, widening by 0.45%. The outperformance was led by our top four positions, which contributed 1.23% and our overweight energy position contributing 0.58%. Weakness in our healthcare holdings muted the outperformance as our three dedicated healthcare CEFs detracted from performance by 0.86%. The Fund’s outperformance when compared to the overall CEF market was more significant as the industry performed terribly in the quarter as the average CEF dropped 3.31%.
During the quarter, we took the portfolio’s equity exposure back up, to 56.98% from 46.71%, after substantially trimming our equity positions in the third quarter. We also added to our fixed income exposure, increasing it slightly from 32.76% to 35.93% as we saw opportunities in fixed income CEFs following the sharp rise in interest rates post-election. Our cash position was 7.09% at year-end as seasonal tax-loss selling opportunities were minimal in 2016. By comparison, we were holding less than 1% cash at the start of 2016. Our largest portfolio additions (in descending order) were in financials, technology, senior loans, high yield, mortgages, and energy, which were funded by our sales and cash.
WHAT HELPED PERFORMANCE
Top Four Holdings
Our top two preferred/bond holdings, Eagle Point Credit 7% 2020 (ECCZ) and Oxford Lane Capital 8.125% 2024 (OXLCN), gained 3.14% and 2.36% respectively in the quarter, beating the Bloomberg Barclays Aggregate Bond Index which dropped -2.98% and the S&P Preferred Stock Index which fared worse at a drop of -3.71%. We continue to like the risk-adjusted returns that ECCZ and OXLCN provide but are cognizant of their callable dates and may reduce further if fixed income CEFs become more attractive.
In addition to the strong performance of our top preferred/bond holdings, our top two CEFs, NexPoint Credit Strategies Fund (NHF) and Boulder Growth & Income Fund (BIF) gained 5.44% and 7.94%, respectively, outperforming the MSCI AC World Index’s paltry gain of 1.30%. NHF and BIF are both poised to profit from rising interest rates and stronger GDP growth as each are positioned in assets that historically benefit from the two. NHF currently maintains significant holdings in equities and high yield which typically outperform when the economy grows. The fund also has a large allocation to loans and collateralized loan obligations which should profit handsomely from the rise in interest rates coupled with the ability to raise distributions as LIBOR is now trading above the floors imbedded in most issuance. For BIF, its exposure to financials is around 45%. Financials were the best performers in the fourth quarter and we expect more of the same as rates rise and regulations on the industry are decreased. Furthermore, financials have been the worst performers since the financial crisis as a combination of increased regulation, record fines, and low interest rates, led to lower returns on equity which resulted in historically low P/E and P/B ratios. We believe the tide is changing and now financials should trade at higher multiples as they are well positioned to profit from both higher interest rates and increased economic activity.
The Fund’s overweight exposure to energy continued to be a driver of strong returns, with our dedicated energy and MLP CEFs gaining a weighted average of 6.16% in the quarter. We entered the fourth quarter with three energy/MLP funds and exited the quarter with six as we diversified our MLP holdings to take advantage of wide discounts in the space. OPEC’s surprise decision in November to curtail oil production after failed talks the prior two years helped support energy prices in the quarter as oil traded at its highest level since July 2015. The election of Donald Trump gave energy investors optimism that regulatory burdens would diminish, providing confidence that U.S. companies across the energy supply chain could grow again. With energy not at the top of Trump’s to do list, we do not expect major legislation immediately that would lessen the regulatory burden of energy companies, but we do expect less interference and no new regulations that would hamper the industry. This should increase confidence by energy companies to proceed with pro-growth plans after shelving additional capital expenditures the last few years due to regulations, high amounts of debt, and low commodity prices. The companies that have survived should thrive as the industry has shrunk due to bankruptcies giving companies with strong balance sheets the ability to grow revenues and add strategic assets.
WHAT HURT PERFORMANCE
The worst two performers in the Fund were Tekla Healthcare Opportunities Fund (THQ) and Tekla World Healthcare Fund (THW). Both funds started off the year terribly as healthcare was the worst performer and neither fully recovered. As a result, they were prime candidates for tax-loss selling which we saw in December as both funds closed the year at double-digit discounts after trading at low single-digit discounts in the quarter. We believe healthcare will rebound in 2017 after a disastrous 2016 as the political overhang of drug pricing and healthcare costs dissipates and large-cap healthcare companies awash in cash return to M&A to help rebuild drug pipelines which should buoy valuations. The space is currently valued as if government-controlled drug pricing is currently in place. The Trump administration has healthcare at the top of its agenda so we believe there will be more clarity for this sector early in his presidency than there will be for some other market sectors.
Our Asian equity holdings saw weakness in the quarter, with Aberdeen Japan Equity Fund (JEQ), Taiwan Fund (TWN), and Templeton Dragon Fund (TDF) dropping more than 6% each. The country allocations dominating these funds are all large exporters to the U.S. With President-elect Trump threatening tariffs on countries that abuse trade deals and campaigning against the Trans-Pacific Economic Partnership Agreement, these funds were directly in the crosshairs and sold off accordingly post-election. The Fund is currently underweight Asia with a 6% allocation, but we are looking to add to our position on continued U.S. dollar strength as possible taxes and tariffs could be mitigated by underlying currency weakness in the region.
Active investment strategies have come under fire the last few years as the underperformance of mutual fund and hedge fund strategies has resulted in outflows from investors reallocating to low cost passive strategies. This phenomena is the result of easy monetary policy lifting all boats, the proliferation of passive low fee ETFs and mutual funds, and overpopulation in the active management space where too many portfolio managers are chasing the same trades. The financial news media has been reporting the weak performance in 2016 of active managers and questioning their future. As very active managers, we believe “reports of our death to be greatly exaggerated.”
The Fund outperformed its benchmark (Class A at NAV) by 6.91% over the last year and 2.55% annually over the last three years. We have, in part, been able to outperform over the past few years investing in actively managed CEFs due to our adherence to our time-tested strategy coupled with the irrational behavior of CEF investors. The efficient-market hypothesis may exist in equities and fixed income where they are dominated by institutional investors but from our extensive experience, CEFs do not subscribe to this theory. The main driver of this inefficient market is that nearly 75% of all investors in CEFs are retail. As a result, we have been able to take advantage of behavioral investing miscues by retail to generate alpha.
We expect alpha generating opportunities for our strategy to increase in 2017 as pro-growth fiscal policies are enacted, the Fed continues to tighten monetary policy, and active investing sees a resurgence. We are already seeing signs of change since the presidential election as defensive stocks and government bonds have been weak while cyclical stocks have been rallying. An increase in volatility can be expected as the Fed is no longer supporting asset prices forcing investors to brush the dust off their fundamental investing text books. With the recent culling of active managers over the past few years, we expect the survivors to be able to outperform in the new environment going forward. This should benefit CEFs significantly as all strategies are actively managed.