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Contrarian Investing with Closed-End Equity Funds: Is Anything Still Cheap?

January 3, 2013
John Cole Scott, CFS
(800) 356-3508

From our experience, if you are interested in closed-end funds then you typically fall into two groups of investors: Dividend Seekers or Contrarian Investors.

Regarding contrarian investing, can investors currently find value amongst the roughly 219 available equity closed end funds? For those not familiar with some of the data we collect and use, please review CEFA’s CEF Data Definitions. Data used in this article is from our weekly CEF data service, “CEFA’s Closed-End Fund Universe” dated December 28, 2012.

Research Criteria: 1) Less than 15% of assets invested in US stocks. 2) Current discount to NAV of more than -10%. 3) Relative discount wider than -1.5% (90 day average discount) 4) Comparable discount (vs. peer group average) wider than -2%. 5) 1-year Z-stat of less than -1.0. 6) Relative Z-stat of less than -0.5. 7) 1-Year discount range under 15%.  8) 52-Week relative market price under 33%. 9) 1 Year NAV total return performance above + 10% through December 28th 2012. 10) Trading more than 30,000 shares per day.

Non US Equity Fund
BlackRock International Growth & Income Fund (BGY)

Current Discount
-13.30%

1-Yr Z-Stat

-1.66

Net Assets

$926M

Total Dist Yield

9.2%

Comp Discount

-3.75%

Relative Z-Stat

-1.57

Daily Liquidity

$4,212K

Leverage

0%

Relative Discount

-1.48%

52 Week Rel Price

31%

MP/NAV Correlation

39%

1-Yr Std Deviation:

17.7

Discount Range

8.16%

Expense Ratio

1.10%

1 Year Mkt Pr TR

+10.4%

1 Year NAV TR

+15.6%

Concerns: 81% of the dividend over the past 90 days is classified as return of capital, however they just cut the dividend by -24% in September of 2012. We anticipate the next quarterly dividend announcement date is Friday, March 1.

US Equity Fund
BlackRock Enhanced Equity Dividend Trust (BDJ)

Current Discount
-13.34%

1-Yr Z-Stat

-2.14

Net Assets

$1,466M

Total Dist Yield

7.9%

Comp Discount

-3.71%

Relative Z-Stat

-1.47

Daily Liquidity

$4,349K

Leverage

0%

Relative Discount

-2.12%

52 Week Rel Price

23%

MP/NAV Correlation

77.3%

1-Yr Std Deviation:

12.1

Discount Range

7.06%

Expense Ratio

1.15%

1 Year Mkt Pr TR

+7.4%

1 Year NAV TR

+10.0%

Concerns: Return of Capital is listed as 73% over the past 90 days, but the trend of RoC is down which we favor. The dividend level was cut -18% in December which often is a better time to buy into a fund.

Conclusion: While we did not search for above normal dividend paying funds when we conducted our research, we ended up identifying funds with significant dividend levels. It should be noted that the average equity CEF currently has a total yield of 7.2% which makes this possibility unsurprising.

Both funds have reported return of capital (RoC) in their recent distribution section 19 notices or press releases. Inside the CEF industry there is both deep concern and investor preference for RoC in a fund’s dividend. Why? The RoC benefit is  that portion of the dividend is not taxed as income or capital gains, but your cost basis is reduced by the RoC amount, effectively making it a tax deferred investment.The risk for RoC is that if the fund cannot earn, produce or grow its dividend policy through its investment work in the portfolio then it will erode NAV over time. This can reduce the ability to produce future dividends as well as reducing liquidity and raising the expense ratio over time.

CEFA advocates active monitoring a funds financial reports as well as data to help anticipate risks beforehand and believes that the current discounts offered in both these funds take RoC   risk into account. We also prefer to buy a fund within a few months of a dividend cut as investors often sell the price down to increase the yield and widening the discount.

CEFA’s Data Definitions: http://www.cefadvisors.com/Download/CEFUDataDefinitions.pdf

Disclosures: CEFA does not hold positions in BDJ or BGY and will not buy any shares for 72 hours. The information and statistical data contained herein have been obtained from sources that Closed-End Fund Advisors (CEFA) believes are reliable, but CEFA makes no representation or warranty as to the accuracy or completeness of any such information or data and expressly disclaims any and all liability relating to or resulting from your use of these materials. The information and data contained herein are current only as of the date(s) indicated, and CEFA has no intention, obligation, or duty to update these materials after such date(s). These materials do not constitute an offer to sell or the solicitation of an offer to buy any securities. CEFA may make decisions for its clients in certain of these securities. CEFA and/or their respective officers, employees, and affiliates may at any time hold positions in any of these securities and may from time-to-time purchase or sell such securities.

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