Despite lagging behind regular stocks, closed-end funds (CEFs) are presenting a buying opportunity for investors. This underperformance is especially beneficial for income seekers, as these 8%-paying funds are overdue for a “snap back” to normal. One such opportunity is the 6.7%-paying Adams Diversified Equity Fund (ADX), which is a core holding and buy recommendation of the CEF Insider service. CEFs focusing on stocks have returned 8.9% over the last year, compared to the stock market’s 28.5%. This performance discrepancy is unusual, as CEFs typically match the S&P 500 and potential outperformance could be on the horizon.
CEFs offer higher yields compared to regular stocks, with an average yield of 8% versus 1.3% for the S&P 500 index fund. This income stream provides a liquidity premium, making these funds more valuable than the assets they hold. Despite this, most CEFs trade at a discount to their net asset value. For investors looking to maximize their income streams, CEFs offer a viable option. The PIMCO Dynamic Income Fund (PDI) is a prime example of a CEF that has outperformed over the years, with a premium that has remained high. This undervaluation is a mistake, as PDI has delivered strong returns entirely in dividends since its inception.
The performance discrepancy between CEFs and stocks can largely be attributed to an averaging problem, similar to the issue with hedge funds. Investing in multiple hedge funds can cancel out gains, resulting in underperformance. Similarly, the performance of equity CEFs as a whole can be dragged down by lower-quality assets. However, standout funds like ADX are outperforming the S&P 500, despite the overall lag in the CEF market. The Federal Reserve’s rate increases have also impacted income investors, driving them towards lower-yielding options like Treasuries. But with the Fed planning to cut interest rates multiple times in the coming years, income investors are expected to return to high-yielding CEFs like ADX.
As interest rates decline and income investors seek higher yields, high-performing CEFs like ADX are likely to see their discounts diminish. Funds like PDI may see their premiums increase, attracting more investors. The Fed’s actions are setting the stage for a similar scenario to the mid-2010s when CEFs outperformed and attracted significant investor interest, leading to discounts turning into premiums. Overall, the current market conditions present a compelling opportunity for investors to capitalize on the potential outperformance of CEFs like ADX in the coming years.
