Buffett Explains Why Smart People Go Broke: Our CEF Criteria

Back in March, we wrote:

Warren Buffett once gave the only three ways that a smart person can go broke, stating:

There’s only three ways that a smart person can go broke…liquor, ladies, and leverage.

While the financial risks associated with the first two “L’s” provided by Mr. Buffett are beyond the scope of Seeking Alpha articles, we will dive into the third “L” in this article to discuss why we don’t buy most Closed-End Funds (i.e., CEFs).

We went on to elaborate on the dangers of using margin in an investment portfolio, and then pointed out that a lot of CEFs make aggressive use of margin debt. While the margin’s impact on the CEF lures in investors with strong returns and juiced distribution yields during market booms, it can set them up for sudden and permanent capital destruction during market crashes.

This simple fact makes us very leery of investing in any heavily margined financial product. In fact, we have been able to crush the performance of the S&P 500 (SPY) in our Core Portfolio at High Yield Investor by adhering to the wisdom of Warren Buffett when he said:

You really don’t need leverage in this world much. If you’re smart, you’re going to make a lot of money without borrowing

With that said – and while we do not buy heavily leveraged CEFs for the aforementioned reason – we do not entirely rule out ever buying a CEF. However, if we were to buy them, these are the qualities we would insist on:

#1. No Use Of Margin/Callable Leverage

As already stated: no matter how aligned the portfolio composition and portfolio management style are with our own, no matter how attractive the trailing returns have been, and no matter how high the yield and/or how large the discount to NAV is, if there is a lot of margin or any other kind of callable leverage present, we steer clear. If we were to play this game, it might reward us richly for a while, but eventually the market will crash, and when it does, we will likely see much of our equity wiped out due to the heavy leverage. On top of that, if it is callable leverage such as margin, these losses would become permanent due to a margin call forcing the CEF to sell stocks at steep losses, thereby locking them in.

We learned this the hard way during the 2020 COVID-19 crash. We held the Nuveen Energy MLP Total Return CEF (JMF), which held high quality investment grade MLPs like Enterprise Products Partners (EPD), MLPX (MLPX), Magellan Midstream Partners (MMP), and Energy Transfer (ET). However, it also held nearly 1/3 of its funds via margin and – when the market crashed – it lost so much equity that it was faced with margin calls, and ultimately had to shut down. As a result, we suffered severe permanent losses on this investment.

Here are some examples of CEFs that we would not buy due to their excessive leverage:

#2. Meaningful Discount To NAV

We also would only buy a CEF if it traded at a meaningful discount to NAV. The reason for this is that CEFs are inherently less efficient than building and managing our own portfolio for three big reasons. First, they are managing larger sums of money, which make transactions less efficient due to having to get a less attractive price each time they want to buy or sell a position than we would be able to with a much lower dollar amount involved.

Second, CEFs tend to diversify heavily in an effort to avoid too much volatility. This leads to them often “diworsifying” (i.e., over diversifying to the point where risk-reward is diminished) instead of concentrating investments on their highest conviction picks. Since we are not trying to meet any volatility mandates for our portfolio and have a long-term focus for our portfolio, we do not mind concentrating in our top 25 or fewer picks in each of our portfolios.

Third, CEFs typically charge pretty high management fees, so there is considerable further drag on total returns.

The only way to justify buying a fund with these intrinsic headwinds is if there is a sufficiently large discount to NAV. This way, we could see the gap to NAV close over time, providing an additional boost to our total return bottom line.

#3. Strong Management Track Record

Third, we would require the fund to have a strong management track record. Much like if we owned a business and were to hire someone else to run it for us, we would want to delegate it to someone that we could trust based on their track record. If the fund has a track record of generating returns at least roughly in line with index funds for that sector and there is a sizable discount to NAV – especially relative to the funds’ historical average discount to NAV – then we feel pretty good about our chances of generating a satisfactory performance over time.

#4. High Distribution Yield

Last, but not least, we would require the fund to pay out an attractive distribution yield. While we do not view this as a requirement for strong total return performance, as high yield investors, we try to fill our portfolios with high yielding securities.

Investor Takeaway

In volatile, uncertain times like these, it is essential to keep callable leverage such as margin out of your portfolio. If we end up in a recession, the global geopolitical scene takes another turn for the worse, and/or the Fed has to continue hiking rates aggressively in order to battle inflation, the stock market could very easily plunge further and in so doing wreak havoc on portfolios.

However, we also would want a meaningful discount to NAV and a strong management track record before we would spring for a CEF in our portfolio. Here are some equity CEFs that look potentially interesting at the moment based on our criteria:

CEF	Leverage	Discount to NAV	Yield
SPE	0%	-9.83%	10.66%
JOF	0%	-14.23%	9.58%
HQH	0%	-5.43%	9.28%
GF	0%	-9.97%	17.27%
CHN	0%	-12.51%	46.79%
BOE	0%	-11.51%	7.62%
TDF	0.17%	-10.26%	33.72%
BGR	0.22%	-12.19%	5.34%
AGD	0.23%	-11.88%	8.22%
BSTZ	0.26%	-12.91%	11.58%
IFN	0.28%	-9.49%	13.07%
BMEZ	0.29%	-12.37%	10.36%
BGY	0.36%	-10.21%	7.95%
AOD	0.42%	-11.52%	8.48%
BCX	1.20%	-14.68%	6.01%
EEA	2.38%	-14.68%	20.46%
NDP	4.38%	-13.83%	6.97%
AIO	4.44%	-11.86%	10.86%
RMT	4.90%	-10.81%	10.93%
KF	5.74%	-14.75%	8.48%
RGT	5.91%	-11.31%	30.49%
TEAF	8.89%	-15.49%	7.79%
GER	9.00%	-19.80%	6.22%
EMF	10.31%	-12.08%	9.29%

Granted, we would need to do further research on the expense ratios involved, as well as the track record and portfolio strategy/composition. In terms of yield, leverage levels, and discount to NAV, they certainly look interesting for further research as they look like they offer attractive current yield and total return potential along with little to no risk of margin-induced capital destruction.