UTG, Closed End Funds, and Leverage


H

honda.lioness

Over the last several months from time to time I have read of certain income oriented investors buying some of the "utilities fund" UTG. I looked at its stats and rolled my eyes. It seemed like the proverbial free lunch. The matter became a more practical one recently, when a dear relative asked me what I thought. The relative thinks the "utilities" descriptor means UTG is safe. The information I see on UTG indicates it is paying around 5.6% dividend yield right now but something like 95% of its holdings are common stock utilities paying well south of 5% dividend yields. The remaining holdings do not look like they would make up the difference to pay the 5.6% dividend and whopping annual 1.7% in fund expenses. UTG is said to be "highly leveraged." The "leverage" part scares me. Can folks here elaborate on what it means for a fund to be highly leveraged? Leveraged means the fund borrows against some collateral, right? Does the fund then use what it borrows buy more shares, short shares, or, well, pay dividends? Are funds like UTG partly hedge funds? I get the feeling high leverage translates to a bit (or a lot) of a Ponzi scheme in this case.
 
T

Tad Borek

Over the last several months from time to time I have read of certain
income oriented investors buying some of the "utilities fund" UTG.
UTG is said to be "highly leveraged." Can folks here elaborate
on what it means for a fund to be highly leveraged?

Many income-oriented closed-end funds (CEFs) use leverage - borrowing -
in an attempt to increase returns. They buy interest- or dividend-paying
securities with the money they have, and borrow additional money in some
way to buy more securities. It works if the total borrowing cost is
lower than the income & gains from the securities purchased.

It is not a free ride as it adds the typical risks of investing with
leverage, which amplifies both gains and losses. If you buy investments
that are extremely volatile in price, "highly leveraged" happens at a
lower level than if you buy stable investments. A CEF prospectus should
describe how the fund borrows money, how much leverage it can use, and
how these risks are managed.

Also: CEFs trade at a discount or premium to net asset value, adding a
risk factor absent with open-ended mutual funds. Nothing to do
w/leverage. Add it up and if the goal is getting 1-2% more yield, an
investor needs to understand that a leveraged, income, CEF has the
potential for price swings much higher than that - up or down.

A good launch point for research is cefconnect.com which reports the
current leverage, discount/premium, holdings, and SEC filings with the
gory details. Like this one, as an example:
http://www.sec.gov/Archives/edgar/data/1263994/000119312514121071/d694347dnq.htm

-Tad
 
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H

honda.lioness

Many income-oriented closed-end funds (CEFs) use leverage - borrowing -
in an attempt to increase returns. They buy interest- or dividend-paying
securities with the money they have, and borrow additional money in some
way to buy more securities. It works if the total borrowing cost is
lower than the income & gains from the securities purchased.
It is not a free ride as it adds the typical risks of investing with
leverage, which amplifies both gains and losses. If you buy investments
that are extremely volatile in price, "highly leveraged" happens at a
lower level than if you buy stable investments. A CEF prospectus should
describe how the fund borrows money, how much leverage it can use, and
how these risks are managed.

Also: CEFs trade at a discount or premium to net asset value, adding a
risk factor absent with open-ended mutual funds. Nothing to do
w/leverage. Add it up and if the goal is getting 1-2% more yield, an
investor needs to understand that a leveraged, income, CEF has the
potential for price swings much higher than that - up or down.

A good launch point for research is cefconnect.com which reports the
current leverage, discount/premium, holdings, and SEC filings with the
gory details. Like this one, as an example:

http://www.sec.gov/Archives/edgar/data/1263994/000119312514121071/d694347dnq.htm

Thanks for all this, Tad. I especially like the from-the-horse's-mouth (assuming UTG's managers are honest) document linked at the end. Thirty-six percent leverage as of January, oh m'goodness. I will pass this onto my relatives.
 
D

David S. Meyers, CFP(R)

Over the last several months from time to time I have read of certain income oriented investors buying some of the "utilities fund" UTG. ... The remaining holdings do not look like they would make up the difference to pay the 5.6% dividend and whopping annual 1.7% in fund expenses. UTG is said to be "highly leveraged." The "leverage" part scares me. Can folks here elaborate on what it means for a fund to be highly leveraged? Leveraged means the fund borrows against some collateral, right?
It's quite common for closed-end funds to use leverage. In fact, the average is probably somewhere around 20-30%. It's especially common for income-oriented funds which use leverage by borrowing short-term at low rates to hold positions in longer-term securities with higher yields. And it *certainly* is dangerous - if rates go up, the longer maturity securities (which effectively includes "perpetual" ones like preferred stock and other high-dividend equities) get clobbered while the interest rates on the rolled over short term debt used to finance it go up. Nevertheless, during times of stable (or declining) rates, this strategy can pay off handsomely. Not a free lunch, but still, a strategy which can work when used well.

As for the "whopping" 1.7% in fund expenses -- note that this includes both the management expenses *and* the interest paid on the borrowed funds. In the case of UTG, they've borrowed about $290million and paid about $3.8 million in interest (per the most recent annual report), so the nominal expense ratio versus the actual management expenses are not exactly the same, and it may be a little bit of apples-to-oranges to compare them against, say, unleveraged funds expense ratios.

None of this is meant to express any opinion of UTG itself - just some general information about leverage and funds.

Another couple of things to note: (a) the amount of leverage may change (especially if management is doing a good job and deleveraging when they should - it's not clear that anyone's all that great at that kind of market timing, though); and (b) additionally, closed-end funds trade on the secondary market and are subject to sometimes substantial discounts or premiums versus the underlying portfolio's NAV - this also adds potential opportunity or risk.
 
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H

honda.lioness

Thank you, David Meyers. This was interesting, helpful and will be shared with the aforementioned relatives.
 

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