Buy the stock not the sector: That’s always my advice when investors have an information and experience edge with a particular industry, such as our focus on utilities and essential services, asserts Roger Conrad, editor of Conrad's Utility Investor.
Nonetheless, I feel comfortable saying my experience as an independent director of Miller Howard High Income Equity (HIE) has provided me some unique insights when it comes to closed-end funds: Mutual funds that trade a fixed number of shares — like individual stocks — on major exchanges.
CEFs offer several advantages for income-focused investors over conventional “open end” mutual funds and ETFs. The biggest stems from the fact they don’t have to make redemptions, since they’re readily tradable usually on the NYSE.
Management of a CEF always knows what capital it has to invest, which in turn enables the fund to utilize yield-boosting strategies such as options writing and borrowing against assets.
Both can be a double-edged sword if a fund is over-exposed at the wrong time. But if handled carefully they can result in consistent distributions several times those of equivalent open-end funds or ETFs, which must always be able to pay back 100 percent of shareholder funds.
I currently track three of these CEFs — Blackrock Utilities and Infrastructure (BUI), Kayne Anderson Energy Infrastructure Fund (KYN) and Reaves Utility Income (UTG). These three are also my favorites among the available CEFs in this sector.
The conservative stock picking and leverage strategies of Blackrock and Reaves have served them very well in recent years. Both have avoided major declines in net asset value, including in February/March of 2020, while continuing to build value.
These funds also avoided dividend cuts during the pandemic year, with Reeves returning to growth in 2021. Both of these CEFs currently trade slightly above net asset value and my highest recommended entry points. I advise patiently waiting for those prices before entering.
Kayne Anderson, in contrast, trades at a double-digit percentage discount to its NAV, a yield of almost 9 percent and well below my highest buy point. That’s because its bread and butter midstream energy holdings are very much out of favor. And though the fund has boosted its quarterly distribution this year, investors still remember last year’s deeper cut.
Nonetheless, Kayne shares have returned better than 80 percent over the last 12 months. And I see three major catalysts for at least equal gains over the next year.
First, the midstream companies it owns are all trading at extremely discounted valuations/high yields, despite Q2 results and guidance that demonstrate they’ve adapted to the current stage of the energy price cycle. And as the cycle moves higher, they’ll close that valuation gap, pushing up NAV.
Second, the fund’s already lofty yield is almost certainly headed higher over the next 12 months. CEFs are required to pay out their holdings’ distributions and Kayne’s 10 largest companies (68.4 percent of the portfolio) are set for payout increases next year. That’s the happy result of rising free cash flows thanks to streamlining measures and steadily improving business conditions.
And third, as Kayne realizes gains in NAV along with distribution growth, it’s likely to close its discount. I rate Kayne Anderson Energy Infrastructure Fund a buy up to 9.
Remember that when you buy a CEF, you’re trusting management to make the right decisions on individual holdings, allocations, market timing and any use of leverage. Funds publish portfolio lineups quarterly and it’s important for investors to check them out. But at any given time, you’re not going to know what’s inside.
Also, a typical CEF pays for its distribution with capital gains and sometimes return of capital in addition to investment income. That can limit upside for NAVs and market prices, especially funds with high current yields.
Both are reasons why I generally prefer to pick my own stocks. But a well-run CEF can provide superior and reliable current income year-in, year-out. And for yield-focused investors in a zero interest rate environment, that can be well worth forgoing some capital appreciation.