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CEF Portfolio Generates 9% Income With Reasonable Risk

Summary The CEF portfolio had an average distribution of 9.4% coupled with lower risk than the S&P 500. The CEF portfolio is diversified among many types of funds including bonds, preferred stocks, equities, and covered calls. Most of the selected CEFs are selling at historically large discounts. As an income focused investor, I’m a fan of Closed End Funds (CEFs), and have written many articles on Seeking Alpha discussing their risks and rewards. Many CEFs have recently taken it on the chin because of fear that the Fed may begin raising rates. To my mind, this has created CEF bargains among many asset classes. This article constructs a diversified portfolio of CEFs that are selling at large discounts and also have reasonable risk-versus-reward profiles. Below is a summary of the CEFs I have selected. I apologize in advance if I did not include your favorite CEF and I welcome alternative suggestions from readers. The data is based on the 2 October market close. BlackRock Corporate High Yield Fund (NYSE: HYT ). This is one of the largest high yield CEFs with a market cap of $1.3 billion. Over the past 5 years, this CEF has sold for a both discounts and premiums. Premiums were relatively rare and reached a high of 6% in 2012. The fund typically sells at a discount, averaging about 5% over the past 5 years but increasing to a 12% average during the past year. The current discount is 15.2%. The portfolio is a combination of high yield bonds (87%) and equities (7%). The fund utilizes 31% leverage and has an expense ratio of 1.3%. The distribution is 8.7%, funded by income with a small amount of Return of Capital (ROC). The ROC is typically only about 1% of the total distribution. Brookfield Total Return Fund (NYSE: HTR ). This fund focuses on mortgage backed securities (MBS). Over the past 5 years this CEF has sold primarily at a discount. The 5 year average discount was 5% but the discount has grown to a 9% average over the past year. The current discount is 16.5%. The portfolio consists mostly of MBS and asset backed securities with the majority coming from the commercial and residential non-agency sectors. About 40% of the bonds are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.3%. The distribution is 10.9%, funded by income with no ROC. Nuveen Credit Strategic Income Fund (NYSE: JQC ). JQC has a market cap of about $1.1 billion and is the largest CEF focused on floating rate loans. Over the past 5 years, this CEF has sold mostly at a discount. The only time this fund sold at a premium was a short period in 2013. The five year average discount is 8% and the one year average is 12%. The current discount is 15.2%. The portfolio consists of a combination of floating rate loans (68%) and corporate bonds (19%). Less than 10% of the holdings are investment grade. The fund utilizes 38% leverage and has an expense ratio of 1.8%. The distribution is 7.6%, funded by income with no ROC. AGIC Convertible and Income Fund II (NYSE: NCV ). This fund focuses on convertible securities. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 15%. It was not until the second half of 2015 that the fund, began selling at a discount. The five year average was a premium of 7% and the 1 year average was a premium of 5%. The current discount is 14.4%. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution was recently reduced but is still 13.3%. The distribution is funded by income with no ROC. Nuveen Preferred Income Opportunities Fund (NYSE: JPC ). This fund focused on preferred shares. Over the past 5 years this CEF has sold only for a discount. The smallest discount was about 1% in 2012. The 5 year average discount is 9% and the 1 year average discount increased to over 10%. The current discount is 11%. The portfolio consists primarily of preferred stock (88%) with a small amount of equities (6%). The fund utilizes 29% leverage and has an expense ratio of 1.7%. The distribution is 9%, funded by income with no ROC. Cohen Steers Quality Income Realty Fund (NYSE: RQI ). This fund is focused on REITs. Over the past 5 years this CEF has sold only at a discount. The discount has oscillated between less than 1% to over 14%. The 5 year average has been a discount of 8% but the 1 year average has increased to a discount of 12%. The current discount is 12.5%. The portfolio consists of a combination of REITs (80%) and preferred stock (19%). The fund utilizes 25% leverage and has an expense ratio of 1.9%. The distribution is 8.6%, funded by income with no ROC. Eaton Vance Enhanced Equity Income Fund II (NYSE: EOS ). This is a covered call fund. Over the past 5 years this CEF has sold for a both a discount and a premium, but mostly at a discount. The premium was as high as 5% in 2010. The premium turned into a discount in 2011 and has stayed at a discount ever since. The discount sunk to 15% in 2011 but has been improving in recent years. The 5 year average has been a discount of about 8% and the 1 year average is only 5%. The current discount is 8.5%. The portfolio consists equities that are used for call writing on about 50% of the portfolio. The fund managers have a flexible mandate and can invest in all size companies but most are medium to large cap. The fund does not use leverage and has an expense ratio of 1.1%. The distribution is 8.4%. The fund has a small amount of ROC but this is not unusual for covered call funds. Cohen & Steers Infrastructure Fund (NYSE: UTF ). This fund focuses on utilities. Over the past 5 years this CEF has always sold at a discount. The discount has grown larger in 2015. The 5 year average has been a discount of about 11% and the 1 year average is 13%. The current discount is 16.8%. The portfolio consists of investments in utility and infrastructure companies. The portfolio contains 80% equities, 10% bonds, and 5% preferred shares. About 60% of the holdings are domiciled in the US. The fund utilizes 29% leverage and has an expense ratio of 2%. The distribution is 8.5% funded by income and capital gains with no ROC. The characteristics of an equally weighted portfolio of these CEFs are summarized in Figure 1. The portfolio has an average distribution of 9.4%, which definitely achieves the objective of high income. The average discount is also large at 14%. (click to enlarge) Figure 1: Portfolio averages Even more important than the value of the discount is how it relates to the average discounts over the past year. This is measured by a metric called the Z-score, which is a statistic popularized by Morningstar to measure how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A good source for Z-scores is the CEFAnalyzer website. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. With the exception of JPC and RQI, the selected CEFs are selling at historically large discounts as evidenced by the large negative Z-score. Both JPC and RQI have large discounts but the discounts are close to the average discount for the year. Figure 2 shows the allocation among asset classes as: bonds (50%), preferred stocks (16%), and equities (33%). Most of the equity portion is hedged by using covered calls. Thus, overall this is a defensive portfolio, which I believe is prudent given the current uncertainties in the market. (click to enlarge) Figure 2: Allocations among asset classes The portfolio looks promising in terms of income but total return and risk are also important so I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the component funds. The risk free rate was set at 0% so that performance could be easily assessed. I equated volatility with risk and used a 5 year look-back period from October 2, 2010 to October 2, 2015. The plot is shown in Figure 3. (click to enlarge) Figure 3. Risk versus reward for past 5 years. In the figure, the risk-versus-reward for each CEF is represented by a green diamond. The performance of the composite portfolio is shown by the blue dot. I also included the SPDR S&P 500 Trust ETF (NYSEARCA: SPY ) ETF as a comparison with the overall market. As is evident from the figure, the CEFs had a wide range of returns and volatilities. Were the returns commensurate with the increased risk? To answer this question, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 3, I plotted a red line that represents the Sharpe Ratio associated with the composite portfolio. If an asset is above the line, it has a higher Sharpe Ratio than composite portfolio. Conversely, if an asset is below the line, the reward-to-risk is worse than the portfolio. You may be surprised that the volatility of the portfolio is smaller than the volatilities of the components. This is an illustration of an amazing discovery made by an economist named Markowitz in 1950. He found that if you combined certain types of risky assets, you could construct a portfolio that had less risk than the components. His work was so revolutionary that he was awarded the Nobel Prize. The key to constructing such a portfolio was to select components that were not highly correlated with one another. In other words, the more diversified the portfolio, the more potential volatility reduction you can receive. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. I calculated the pair-wise correlations associated with the funds. The data is presented in Figure 4. All the CEFs had relatively low correlations with SPY and each other. The only large correlation is the covered call CEF with the S&P 500. This is not surprising since large and medium cap companies were used for writing covered calls. Overall, these results were consistent with a well-diversified portfolio and hence, the reduction in portfolio volatility. (click to enlarge) Figure 4. Correlations over the past 5 years. Some interesting observations are apparent from Figure 3. SPY generated a higher return than the portfolio but SPY also had a higher volatility. SPY and the portfolio had virtually the same risk-adjusted performance. Thus, I believe that the composite portfolio is a good tradeoff for the risk averse investor looking for income. To get additional views of the how the portfolio performed, I analyzed two other metrics. The first is graphed in Figure 5 and shows the growth of wealth over the 5 years period. The plot assumes that the portfolio is frequently rebalanced to maintain equal weighting. As illustrated by the graph, wealth grew at a steady pace over the 5 year period. (click to enlarge) Figure 5 Growth of wealth for CEF portfolio The value of the portfolio decreased a few times along the way. The second metric is plotted in Figure 6 and provides a measure of the draw downs that an investor would experience. The figure illustrates that you can expect periods of relatively large draw downs, which could reach as high as 14% in a few cases. Thus, the portfolio is best suited for long term investors who can weather moderate draw downs. Note that we are currently in a 10% drawdown period, which is similar to draw downs in the past. (click to enlarge) Figure 6. Draw downs associated with the CEF portfolio Bottom Line Many of the CEFs in this portfolio have recently taken price hits, which have resulted in large discounts. No one knows what the future may hold but if the future is anywhere close to the past, these CEFs will recover and the discounts will revert back to the mean. If this turns out to be true, you can receive high income while you wait. Overall I believe this portfolio provides high income with reasonable risk.

Is It Time To Buy Convertible Bond CEFs?

Summary Convertible bond CEFs have been hit hard lately, resulting in historically large discounts. Convertible bond CEFs offer enticing income while you wait for the sector to recover. My pick is NCZ, which is currently selling at a large discount and provides a distribution of 12%. In February of this year, I wrote an article advising investors to beware of convertible bond closed end funds (CEFs). At that time, I cautioned that premiums could disappear. As it turned out, my fears was well founded. In July of this year, the premiums morphed into large discounts. After the selloff, I now believe some of these CEFs are selling at bargain levels. Part of my reasoning is based on the currently large negative Z-scores associated with these CEFs. Z-score is a metric popularized by Morningstar and is a measures how far a discount (or premium) is from the mean discount (or premium). The Z-score is computed in terms of standard deviations from the mean so it can be used to rank CEFs. A negative Z-score indicates that the current discount is larger than the average discount over the past year. A Z-score more negative than minus 2 is relatively rare, occurring less than 2.25% of the time. A good source for reviewing Z-scores is the CEFAnalyzer website. Most of the convertible CEFs currently have Z-scores more negative than minus 2. Before jumping into analysis of the risk versus rewards of convertible CEFs, I will recap some of the characteristics of this asset class. A “convertible security” is an investment that can be converted into a company’s common stocks. A company will typically issue a convertible security to lower the cost of raising money. For example, many investors are willing to accept a lower payout because of the conversion feature. The conversion formula is fixed and specifies the conditions that will allow the holder to convert into common stock. Therefore the performance of a convertible is heavily influenced by the price action of the underlying stock. As the stock prices approaches or exceeds the “conversion price” the convertible tends to act more like an equity. If the stock price is far below the conversion price, the convertible acts more like a bond or preferred share. Convertible bond CEFs usually contain a mixture of convertible securities and high yield bonds. The attraction of convertible CEFs is that they offer upside potential with some protection on the downside. Granted that with a portfolio of high yield bonds and convertibles the downside protection is limited. However, over the long run, the fund manager seeks to obtain the “sweet spot” between fixed income and equity that will enable him to outperform his peers. The funds that were analyzed in my previous article are summarized below. AGIC Convertible and Income (NYSE: NCV ). Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 14%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 7.5% and the 1 year average was still a premium of 5.7%. The fund is now selling at a discount of over 10% and has a Z-score of negative 2.55. The portfolio consists of a combination of convertible bonds (58%) and high yield bonds (41%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.5%, funded by income with no return of capital (NYSE: ROC ). AGIC Convertible and Income II (NYSE: NCZ ). This is a sister fund to NCV and over the past 5 years, the prices of these two funds have been 90% correlated. So if you invest in one of these funds, you gain virtually no diversification from investing in the other. Over the past 5 years, this CEF has sold mostly at a premium, sometimes as high as 17%. It was not until the second half of 2015 that the fund began selling at a discount. The five year average has been a premium of 10.4% and the 1 year average was a premium of 9.4%. The fund currently sells for a discount 9.4% and has a Z-score of negative 2.4. The portfolio consists of a combination of convertible bonds (57%) and high yield bonds (42%). Less than 10% of the holdings are investment grade. The fund utilizes 33% leverage and has an expense ratio of 1.2%. The distribution is 12.4%, funded by income with no ROC. Calamos Convertible and High Yield (NASDAQ: CHY ). Over the past 5 years this CEF has sold for a both a discount and a premium. The premium was as high as 5% in early 2015 but by late 2015 the fund sold at a discount. The 5 year average discount has been 2.9% but over the past year, the fund averaged a slight premium of 0.3%. The current discount is 8.6%. The portfolio consists of a combination of convertible bonds (55%) and high yield bonds (40%). Less than 15% of the holdings are investment grade. The fund utilizes 29% leverage and has an expense ratio of 1.5%. The distribution is 10.6%, funded by income with only a small amount of ROC. The UNII is negative and quite large when compared with the distribution, which may be a concern for maintaining future distributions. Calamos Convertible Opportunities and Income (NASDAQ: CHI ). Over the past 5 years this CEF has sold for a both a discount and a premium, alternating frequently between discount and premium. The premium was as high as 4% in 2011 but by late 2015 the fund sold at a large discount approaching 14%. The 5 year average discount has been less than 1% and over the past year, the fund’s average a discount has been 1.8%. The fund is currently selling at an 11% discount and has a Z-score of negative 2.05. The portfolio consists of a combination of convertible bonds (56%) and high yield bonds (39%). Less than 15% of the holdings are investment grade. The fund utilizes 28% leverage and has an expense ratio of 1.5%. The distribution is 10.9%, funded by income with only a very small amount of ROC. The UNII is negative and quite large when compared with the distribution, which is red flag for future distributions. This is a sister fund to CHY but over the past 5 years these two funds have only been 80% correlated so you receive a small amount diversification if you own both of these CEFs. Advent Claymore Convertible and Income (NYSE: AVK ). Over the past 5 years, this CEF has always sold at a discount. The five year average has been a discount over 8% and the 1 year average is an even higher discount of 10.5%. The current discount is a large 16.8%, which translates into a Z-score negative 2.78. The portfolio consists of a combination of convertible bonds (64%) and high yield bonds (31%). About 10% of the holdings are investment grade. The fund utilizes 37% leverage and has an expense ratio of 2%. The distribution is 8.1%, funded by income with a substantial (40%) ROC component. UNII is negative and large compared with the distribution. Advent Claymore Convertible Securities and Income (NYSE: AGC ). Over the past 5 years, this CEF has usually sold at a discount. The only premium was for a short time in 2010 and was less than a 5% premium. The five year average has been a discount of 8.7% and the 1 year average is an even higher discount of 13.8%. The current discount is over 17%, which translates into a Z-score of negative 1.95. The portfolio consists of a combination of convertible bonds (63%) and high yield bonds (28%). The portfolio also has a small (5%) equity component. About 10% of the holdings are investment grade. The fund utilizes 40% leverage and has an expense ratio of 3.1%. The distribution is 10.1%, funded by income with a substantial (70%) ROC component. UNII is negative and large compared with the distribution. Even though AGC is in the same family as AVK, the prices of these CEFs have been less than 60% correlated over the past 5 years. As a reference, I compared the performance of the convertible CEFs to the following exchange traded fund (ETF). SPDR Barclays Convertible Securities (NYSEARCA: CWB ) . This is the largest and most liquid convertible bond ETF. The fund was launched in 2009 and holds about 100 convertible bonds. ETFs are constructed so that they typically sell very near NAV, so there is no discount or premium. ETF has an expense ratio of 0.4% and yielded 4.5% over the past year. To assess the performance of the selected CEFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility of each of the component funds over the past 5 years (from August, 2010 to August, 2015). The risk free rate was set at 0% so that performance could be easily assessed. This plot is shown in Figure 1. Note that the rate of return is based on price, not Net Asset Value (NAV). (click to enlarge) Figure 1: Reward versus risk over past 5 years The figure indicates that there has been a wide range of returns and volatilities associated with convertibles CEFs. For example, NCV had a high return but also a high volatility. Was the return worth the increased volatility? To answer this question, I calculated the Sharpe Ratio for each fund. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. On the figure, I also plotted a red line that represents the Sharpe Ratio of NCV. If an asset is above the line, it has a higher Sharpe Ratio than NCV, which means it has a higher risk-adjusted return. Conversely, if an asset is below the line, the reward-to-risk is worse than NCV. Some interesting observations are apparent from the plot. With the exception of AGC, the convertible CEFs had a respectable return over the past 5 years even though they recently sold off. Since CWB did not sell at a premium or a discount, it is not surprising that it had the best risk-adjusted performance over the period of the analysis. Looking at only CEFs, CHY, CHI, and NCV had nearly the same risk-adjusted performance. NCZ was close behind. AGC was the worst performer and only barely stayed in positive territory. The volatility of convertible CEFs ranged from about 15% to 17% (this is similar to the volatility of the S&P 500 over the same period) The 5 year look-back data shows how these funds have performed in the past. However, the real question is how they will perform in the future when the bull market in convertibles returns. Of course, no one knows, but we can obtain some insight by looking at the most recent bull market period from June, 2012 to September, 2014. Figure 2 plots the risk versus reward for the funds over this bull market time frame. As expected, all the funds did well. The performance of the CEFs were tightly bunched but NCZ was the clear leader among the CEFs. Somewhat surprisingly, CWB still turned in the best risk-adjusted performance. However, NCZ had the best return on an absolute basis. (click to enlarge) Figure 2 Risk versus reward over a convertible bull market Bottom Line Convertible bond CEFs have taken it on the chin lately and the discounts have widened to historic proportions. Is it time to buy these CEFs? To my mind, the answer is yes, especially NCZ. NCZ is currently selling at a discount, which is rare. If the discount reverts back to the mean, you will receive a capital gain along with collecting 12% in distributions. Not a bad combination! Of course, the discount could widen and it may time a long time for this CEF to recover, but I am willing to wait. CHY has had exceptional performance in the past and is also selling at steep discounts. This would be another alternative but I am a little worried about the large UNII and ROC. If you are risk adverse, you may want to consider CWB. There is no doubt this is the best in terms of risk-adjusted performance. However, you will not receive any “reversion to the mean” benefits. I normally choose asset with the best risk-adjusted returns but in this case, I am willing to take a slight gamble and go with NCZ. This is a special situation where I think I can capitalize on the selloff in CEFs and hope for that the large discount associated with this CEF will revert back to the mean.

Choosing The ‘Best’ REIT CEF

Summary Over the past 8 years, only RNP has consistently outperformed VNQ on a risk-adjusted basis. REIT CEFs help diversify an S&P 500 focused portfolio. Domestic REIT funds outperformed international REIT funds over most of the timeframes analyzed. In November, 2014, I wrote an article expounding the benefits of Real Estate Investment Trusts (REITs). Unfortunately, in late January of this year, REITs hit a speed bump, many dropping by 15% or more. The likely reason was the fear that REIT prices would fall when the Fed raised interest rates. However, since the Fed will likely not raise rates unless the economy is thriving, increased rates may not be all bad for REITs. A robust economy typically bodes well for real estate and according to REIT.com , during the 16 periods since 1995 where interest rates rose significantly, equity REITs generated positive returns in 12 of the periods. As a retiree looking for income, I am a fan of REITs. I own some individual REITs but I tend to gravitate to REIT funds, especially Closed-End Funds (CEFs) because of their high distributions. As prices have decreased, the discounts associated with REIT CEFs have widened and the distribution percentages have increased. If you believe the weakness is temporary, now may be a good time to consider adding REITs to your portfolio. There are currently 12 CEFs focused on REITs, so the question is, which funds are “best.” There are many ways to define “best.” Some investors may use total return as a metric, but as a retiree, risk is as important to me as return. Therefore, I define “best” as the fund that provides the most reward for a given level of risk and I measure risk by the volatility. Please note that I am not advocating that this is the way everyone should define “best”; I am just saying that this is the definition that works for me. This article will analyze the REIT CEFs to assess relative risk-adjusted performance since the bear market of 2008. Along the way, I will also compare the REIT CEFs to Exchange Traded Funds (ETFs). However, before jumping into the analysis, it will be useful to review some of the characteristics of this asset class. In 1960, Congress created a new type of security called REITs that allowed real estate investments to be traded as a stock. The objective of this landmark legislation was to provide a way for small investors to participate in the income from large scale real estate projects. A REIT is a company that specializes in real estate, either through properties or mortgages. There are two major types of REITs: Equity REITs purchase and operate real estate properties. Income usually comes through the collection of rents. About 90% of REITs are equity REITs. Mortgage REITs invest in mortgages or mortgage-backed securities. Income is generated primarily from the interest that is earned on mortgage loans. The risks and rewards associated with mortgage REITs are very different than those associated with equity REITs. This article will only consider equity REITs. One of the reasons REITs are so popular is that they receive special tax treatment, and as a result, are required to distribute at least 90% of their taxable income each year. This usually translates into relatively large yields. But because REITs must pay out 90% of their income, they rely on debt for growth. This means that REITs are sensitive to interest rates. If the interest rates rise, the cost of debt increases and the REITs have less money for business investment. However, as we have discussed, rising rates usually imply increased economic activity, and as the economy expands, there is a higher demand for real estate, which is positive for REITs. To narrow the analysis space, I used the following selection criteria: A history that goes back to 2007 (to see how the fund reacted during the 2008 bear market). Generally, REITs were devastated in 2008, but, like other equities, they have recovered strongly since 2009. A market cap of at least $100M An average daily trading volume of at least 50,000 shares The 7 CEFs that passed the screen are summarized below. Nuveen Real Estate Income ( JRS ). This CEF sells for a discount of 7.6%, which is unusual since over the past 5 years the fund has sold at an average premium of 3.3%. The fund has 93 holdings with 57% invested in REITs and the rest in preferred stock. The REIT’s holdings are spread over all types of properties (retail, office, residential, healthcare, hotels). As with most REITs, the price of the fund dropped over 60% in 2008, but rebounded strongly in 2009, gaining 89%. The fund utilizes 29% leverage and has an expense ratio of 1.8%, including interest payments. This distribution is 9%, funded from income and capital gains, with no return of capital (NYSE: ROC ) over the past year. Neuberger Berman Real Estate Securities Income Fund ( NRO ). This CEF sells for a discount of 16.3%, which is larger than its 5-year average discount of 12.8%. The fund consists of 70 holdings with 66% in diversified REITs and 33% in preferred shares. The price of the fund fell a whopping 78% in 2008, but rebounded over 100% in 2009. The fund uses leverage of 27% and has an expense ratio of 1.7%, including interest payments. The yield is 7.4% funded primarily from income with no ROC. Cohen and Steers Quality Income Realty Fund ( RQI ). This CEF sells for a 13% discount, which is larger than its 5-year average discount of 8.4%. The fund has 126 holdings consisting of REITs (82%) and preferred stock (16%). The price of this fund fell 68% in 2008 and gained 80% in 2009. The fund utilizes 24% leverage and has an expense ratio of 1.9%, including interest payments. The distribution is 8.5%, consisting primarily of income and long-term gains with no ROC. Cohen and Steers Total Return Reality (NYSE: RFI ). This CEF sells for a discount 9%, which is larger than the 5 year average discount of 0.9%. The portfolio consists of 143 securities with 80% in diversified REITs and 19% in preferred stocks. This fund does not use leverage and has an expense ratio of 0.9%. The distribution is 7.7% with no ROC. Cohen and Steers REIT and Preferred Income Fund ( RNP ). This CEF sells for a discount of 15.6%, which is larger than its 5-year average discount of 9.9%. The portfolio consists of 206 holdings with 50% in REITs and 48% in preferred shares. The fund lost 60% in 2008 and rebounded strongly in 2009, gaining over 90%. The fund uses 25% leverage and has an expense ratio of 1.7%, including interest payments. The distribution is 8.3%, consisting primarily of income with about 40% ROC over the past 6 months. The undistributed net investment income (UNII) is positive so I would consider the ROC to be non-destructive. CBRE Clarion Global Real Estate Income ( IGR ). This CEF sells for a discount of 15.1%, which is larger than its 5-year average discount of 9.7%. The portfolio consists of 57 securities with 90% in REITs and the rest in preferred shares. About 50% of the holdings are from the United States with the rest spread over Asia, Europe, Australia, and Canada. The fund dropped 67% in 2008 and gained 79% in 2009. This fund uses only a small amount of leverage (9.6%) and has an expense ratio of 1.1%. The distribution is 7.4%, consisting of income and ROC in roughly equal parts. Some of the distribution appears to be destructive since UNII is negative and is large when compared to the distribution. Alpine Global Premier Properties Fund ( AWP ). This CEF sells for a discount of 13.8%, which is larger than its 5-year average discount of 11.4%. The portfolio consists of 105 holdings with almost all (99%) in REITs. Only 30% of the holdings are domiciled in the United States. The next largest geographical weightings are Japan at 15% followed by the UK at 10% and China at 8%. The fund lost 63% in 2008 and rebounded 79% in 2009. The fund uses only a small amount (2%) of leverage and has an expense ratio of 1.3%, including interest payments. The distribution is 9.2% consisting primarily of income and about 40% ROC. Some of the distribution appears to be destructive since UNII is negative and is large when compared to the distribution. For comparison, I used the following Exchange Traded Funds (ETFs). Vanguard REIT Index ETF ( VNQ ). This ETF was launched in 2004 and tracks the MSCI US REIT Index, which is a pure equity REIT index. The index is diversified across real estate sectors with retail being the largest constituent at 27% followed by Office (15%), residential (15%), and health care (15%). The fund lost a relatively low 37% in 2008 and recovered 30% in 2009. The fund charges a miniscule 0.12%, which is substantially less than most of its competitors. The fund yields 4.1%. SPDR Dow Jones International Real Estate (NYSEARCA: RWX ). This ETF offers exposure to foreign real estate REITs. It holds 120 securities with 54% domiciled in the Pacific region (21% from Japan and 12% from Australia) and 36% domiciled in Europe. This fund lost 50% in 2008 and recovered 36% in 2009. The fund has an expense ratio of 0.59% and yields 3%. For the funds that met my criteria, I plotted the annualized rate of return in excess of the risk-free rate (called Excess Mu on the charts) versus the volatility for each fund. This data is shown in Figure 1. The risk-free rate was assumed to be 1%. The Smartfolio 3 program was used to generate this chart. (click to enlarge) Figure 1. Risk versus reward over bear-bull cycle Figure 1 illustrates that REIT funds have had a large range of returns and volatilities. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with VNQ. If an asset is above the line, it has a higher Sharpe Ratio than VNQ. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Some interesting observations are evident from the figure. With the exception of RWX, REIT funds had similar volatilities but significantly different returns. Somewhat surprisingly, RWX was by far the least volatile fund but it also had the least return. RQI and NRO were the most volatile. Over the bear-bull cycle, three funds (RFI, VNQ, and RNP) outperformed the other funds on a risk-adjusted basis with RNP eking out the best performance by a small margin. The international REIT funds (RWX, AWP, and IGR) substantially lagged the domestic REIT funds. RQI had relative good absolute performance but, when coupled with the high volatility, had the fourth best risk-adjusted performance. One of the reasons often touted for owning REITs is the diversification they provide. To be “diversified,” you want to choose assets such that when some assets are down, others are up. In mathematical terms, you want to select assets that are uncorrelated (or at least not highly correlated) with each other. To assess the degree of diversification, I calculated the pair-wise correlations associated with the REIT funds. To round out the analysis, I also included SPDR S&P 500 (NYSEARCA: SPY ) to represent the overall stock market. The results are provided as a correlation matrix in Figure 2. (click to enlarge) Figure 2. Correlation matrix over bear-bull cycle As is apparent from the matrix, REITs did provide a reasonable amount of portfolio diversification. The REIT CEFs were about 70% correlated with SPY. The CEFs were also not highly correlated with each other or with the REIT ETFs (with correlations ranging from 60% to 80%). As you might expect, the Cohen and Steers REIT funds were more correlated with each other than with others funds, but they still offered relatively good diversification. Next, I looked at the past 5-year period to see if the REIT performance had significantly changed. The results are shown in Figure 3. The performances were tightly bunched, but RNP was still the best performer with NRO and RQI both beating VNQ. The international funds improved but still lagged. (click to enlarge) Figure 3. Risk versus reward over past 5 years As a final test, I re-ran the analysis over the past 3 years and the results are shown in Figure 4. What a difference a couple of years made! Over this period, the two ETFs (RWX and VNQ) plus RNP have generated the best risk-adjusted performance. AWP and NRO also had relatively good performance with RQI, RFI, JRS, and IGR lagging. IGR had the worst performance among all the funds. (click to enlarge) Figure 4. Risk versus reward over past 3 years Bottom Line REITs have had good performance in the past but have recently fallen on hard times. If you believe that REITs currently offer a buying opportunity, I recommend either VNQ or RNP, depending on whether you prefer ETFs or CEFs. I would steer clear of international funds since their performance has not be consistent over the years. Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in VNQ,RNP over the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.