Tri-Continental (NYSE:TY) is an equity-focused closed-end fund. The fund aims for long-term capital growth and has the flexibility to invest throughout a company’s capital structure if desired. The bottom falls into the Morningstar Large Value box and has the S&P 500 as its benchmark. According to fund documentation, TY “uses robust sector- and industry-specific models to evaluate stocks based on three broad subcomponents: quality, valuation, and catalysts (sometimes referred to as momentum).” The fund only distributes what it receives from its underlying holdings, hence the meager dividend yield of 3.6%. However, the fund’s net asset value has increased significantly over the past few years, with rolling 5- and 10-year total returns of 13.6% and 13.2%, respectively.
The vehicle has a very robust Sharpe ratio of 0.85, with a standard deviation of 14.46, both observed over a 5 year retrospective. The fund’s peak drawdown occurred during the Covid pandemic and it reached -24.9%, whereas a normal cycle drawdown is only -15%. The fund uses the minimum leverage required (less than 2%) to belong to the CEF category. The fund has strong long-term returns, but has failed to outperform the index over 5 or 10 years. While we like the fund and its analytics, for equity-focused CEFs, we would like to see some alpha generation, ie outperformance of the index.
TY is a very robust CEF that uses minimal leverage and has shown very healthy long-term results. However, in the absence of index outperformance for this fund, we find it difficult to understand why an investor would buy TY and not the index outright. If a retail investor is already invested in the name, we assign them a rating Holdwhile any new money looking to enter the space would be well advised to wait for an outsized NAV discount for the fund.
The fund has 231 stocks compared to the S&P 500 index:
TY chose a portfolio that has a lower P/E ratio than the index (15.5 for the fund versus 21.2 for the index) and a lower Price/Book ratio as well. Fund managers actively seek to identify stocks that have alpha generating capabilities and are able to outperform the index over the long term.
According to the fund literature:
for a portion of the fund, the fund uses a quantitative strategy that rates stocks based on three broad subcomponents: quality, valuation, and catalysts (sometimes referred to as momentum). Additionally, part of the fund uses a fundamental strategy that takes a holistic view, exploring all types of securities issued by a company to determine the best risk/return profile for the portfolio.
Currently, TY’s top holdings are:
All of the names are large-cap stocks, and while the first three are growth-oriented, the rest are mostly in the value category. From a sector perspective, the allocation of funds is as follows:
TY has a lower technology allocation than the S&P 500 and makes up for the shortfall in healthcare, financials, utilities and energy.
The fund has posted a performance very similar to that of the index since the beginning of the year:
On a 3-year basis, however, TY slightly underperformed the S&P 500:
Longer-term performance is similar, with TY exhibiting very strong returns but still lagging the S&P 500 Index:
The bottom line here is that TY is a very strong and robust fund, but it fails to beat the index over the long term. Although the fund takes a very quantitative approach to identifying undervalued stocks to generate alpha for investors in the fund, the long-term results indicate underperformance of the index.
Premium/Rebate to NAV
The fund typically trades at a substantial discount to net asset value:
Currently, TY is discounted almost -13%, sitting in the middle of the historical range. We can assume that the low dividend yield the fund pays is responsible for the large discount to NAV.
The fund aims to distribute only the underlying cash flows that the portfolio assets produce in accordance with the fund documentation:
The fund has an earned distributions policy, which means that the fund intends to make distributions to ordinary shareholders which are approximately equal to all distributions received by the fund from its underlying portfolio investments, less any expenses of the fund and dividends payable on the preferred shares of the fund. Distributions vary and are subject to change.
Unlike other CEFs that use capital gains to create a very high dividend yield, TY prefers to grow NAV and implicitly market price through its performance. From this point of view, it can be classified as a more conservative CEF.
TY is an equity-focused CEF. Unlike other vehicles in the space, the fund focuses on increasing net asset value and only distributes the cash flows it receives to the portfolio of underlying assets, hence the low yield of 3.6%. With strong long-term results, TY shows favorable risk/reward analyzes achieved with less than 2% leverage.
Although the fund posted healthy returns, it failed to beat the S&P 500 index over a 5- and 10-year period. If a retail investor is already invested in the name, we assign them a rating Holdwhile any new money looking to enter the space would be well advised to wait for an outsized NAV discount for the fund.