Operational Questions & Answers - Part 3

Speaking of CEFs (Closed End Funds):

Why can't your Selection Criteria  be used with respect to CEFs? 

• The stock selection strategy of the Brainwashing book tracks individual, Investment Grade Value Stocks. Although CEF common shares represent individual Investment Companies, the investment purpose is significantly different. The CEF shares are being purchased because they represent the experience of a diversified portfolio of Income or Equity Securities.
• Yes, you should still look to sell them and move on to another if the 10% gain objective is reached, but there is no need to look for a 20% decline in price for a purchase decision. With an income fund, focus on the yield, avoiding those that are unusually high or low, and diversify with a maximum of 10% to 15% if possible. 
• Yes, I do use Equity CEFs, and not just in very small managed portfolios, where they are the primary security. When the Buy List shrinks to 10 or fewer issues, you can steal some Capital Gains dividends while continuing to participate in a broad rally with one or two of the better CEFs. With an Equity Fund, diversify with a maximum of 15% to 20% in portfolios under six figures, and normally (5%) above that level. 
• I absolutely never touch an Index CEF. 
• For a more complete discussion, and links to other websites (click here).

What do you use to rate the quality of CEFs? 

• Actually, I don't use a rating guide at all. Remember that these are portfolios of securities of a (presumably) less risky nature so an absolute rating of quality might be a little hard to believe in. I look at the range of price movement over a minimum of three to five years to assess risk based on the current price, and try to avoid buying at extremely high historical levels, when possible.
• The next issue is reasonableness of the yield vs. the amount of leverage used. Avoid excessively high or low leverage in the same way that you avoid excessively high or low yields.
• The relationship to NAV is certainly important to consider, but don't let it become the primary issue.
• The S & P Stock Guide is still the one. Most of the information you need is provided, toward the back of the book.
• A significant issue, and this is something you need to develop, is confidence and experience with these securities both generally and specifically. It takes time and patience.
• Remember, the ability to trade is a secondary benefit of income CEFs.

Do you have some volume number for CEFs below which you wouldn't purchase one of them?

• No, not really. In Income CEFs, low volume may be symbolic of the satisfaction of existing shareholders with a steady, dependable cash flow, and not a real shortage of shares. If the price is right, they'll trade. Think about the underlying security... built to hold on to.
• Another reason for lower volume, at this time of year (3rd or 4th Quarter), could be the habit of some CEFs to pay their Capital Gains and/or special dividends after January 1st. This is always something to consider, and information that you can ask your broker to investigate.
• On the flip side, it's generally a good time to buy CEFs after all of the irregular dividends have been sent to shareholders,,, theoretically, the prices should be a bit lower. So check the early year volume to get the big picture.
• Here's a rare tax note. When you own CEFs, it's likely that some of the dividends you receive in January will be booked as the prior year's income... check with your accountant before you rush to get that 1040 on its way.

How does one determine how much leverage a CEF might be using to boost it's yield?

• Go ETF Connect: http://www.etfconnect.com/education/fundamentals_etf.asp
• Click on Fund Sponsors and find the drop down menu on the left side of the page. Scroll down to the appropriate company name and select it. Then locate the symbol of the fund you are researching.
• Finally, scroll down through the fund details until you locate the information on Preferred Shares and leverage %.
• Take a look at a dozen or so to get a feel for the normal amount of leverage. Note that leverage only sounds like a bad thing. It's an excellent business practice, and one that is used in all fields... not just by investment companies.