Closed-End Funds: The Preferred Way to Play the Financials

I've been meaning to add some financials to my portfolio ever since the subprime crisis began. I traded Goldman Sachs (GS)  for some short-term profit recently, but in general found the headlines a little too hard to handle. Okay, so that was a bit tongue in cheek. I actually have a couple names in this sector on my short shopping list again. But the point I'm trying to make is that there is a less risky way to play the financials -  through their preferred shares, or you can do even better through closed-end funds of those preferreds that are trading at a discount to NAV.

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Above is a list of closed-end funds of preferred stocks, provided by the WSJ market data center. I looked up these ticker symbols, with emphasis on the ones trading at significant discount to NAV at ETFconnect.com, my favorite site for doing research on closed-end funds. What I found most interesting was Nuveen MultiStrategy Income and Growth Fund 2 (JQC) [and its close cousin Nuveen MultiStrategy Income and Growth Fund (JPC)], both managed by Nuveen.

As of May 29, JQC had a distribution rate of 10.39% and was trading at a 11.82% discount. Its top holdings are Wachovia (WB), Citi (C), Banco Santander (STD), ING (ING), AgFirst Farm Credit Bank, JPMorgan (JPM), Lincoln National (LNC), HSBC (HBC), Developers Diversified Realty (DDR), and Ace Limited (ACE). I doubt many of these companies will go bankrupt, and even if they do, the preferred holders have precedence over common stock holders in claiming any assets.

The chart on JQC shows that it has pared back some losses sustained since last summer. I would love to get my hands on shares below $10, but I may have to wait an aweful long time.

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Going back to my statement that the preferreds are less risky way than the common stocks (for financials), below is the long term JQC: Select Sector SPDRFinancial (XLF) ratio chart. There wasn't any sustained down draft (longer than say, six months), and currently we're in a period of upswing. Combined with its yield and the discount to NAV as a cushion, JQC is quite attractive right now. In fact, in my on-going portfolio rebalance, I have switched out of my short government bond fund in lieu of JQC in the fixed income allocation.

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Comments

[Xyrus]

Not to second guess your investment decision, but there are some things to consider before investing in something like JQC.

First and foremost, JQC (like a number of other closed end funds) has a managed distribution policy in place. For those who don't know, a managed distribution policy means the fund pays out a regular amount at whatever interval they specify (monthly, quarterly, etc.). The good part is that you get income you can count on every month without any fluctuation. The bad part is, if the earnings of the fund are less than what is required for the payout, they return capital. That's not necessarily a bad thing (like for retirees), but before you follow the sweet dividend yields make sure you're not just getting your money back. According to CEFA, the income only yield was 6.99% but the distribution is over 10.7%.

Second, XLF has an expense ratio that is 0.75% less than JQC. That should be factored in as well.

Third, XLF has outperformed JQC over the long haul, though JQC has only been around a couple of years so that may not mean much.

Lastly, there is at least one ETF that invests in preferred securities. PGX is a fairly new ETF that invests in a bucket of preferred securities, many of them in the banks you listed off. It currently yields around 7.3%, which isn't too shabby for an unleveraged ETF. Plus it doesn't have any hidden gotchas that closed end funds can have.

~X~

[JCCIII]

Also, one may consider PGF, Powershares Financial Preferred ETF, currently yielding (per Yahoo! Finance) 6.83%.