USA - USA: Buyer Beware

2023-11-22 22:53:13 ET

Summary

• The fund significantly underperformed the S&P 500 since 1986.
• The fund's 10% distribution policy often results in returning capital to investors, diluting performance.
• The fund's portfolio has a low upside potential and may struggle to meet the 10% distribution requirement in 2024.

Summary

At first glance, the Liberty All-Star Equity ( USA ) closed-end fund appears to be an interesting investment option. The fund selects five asset managers with different investment strategies, including value and growth, and maintains a reasonably diversified and weighted portfolio. However, upon comparing the fund's price performance with the S&P 500 ( SPX ), I found that it significantly underperformed. The fund's issue is structural; it distributes 10% of NAV (quarterly) regardless of dividend income or capital gains, which forces it to return capital, hindering investment compounding.

Performance

The USA fund has a very long track record dating back to 1986 but its AUM has rarely surpassed US$2bn i.e. which is a red flag. I compared the USA vs the SP500 and found massive underperformance. The first chart is based on the fund's price performance which shows it does not grow. The second chart adds in dividend distribution, a much better results but still underperforming the market by a wide margin.

Return of Capital

The fund will pay out 10% of NAV on a quarterly basis independently of dividends or capital gains generated by the various asset managers. This means that in many years USA pays investors with their own money i.e., return of capital. If the investor has automatic reinvestment, then they are literally buying more shares with their own funds and diluting performance.

I looked at the fund's tax records from inception and found that it returned capital in 21 years out of 36 years with about 1/3 of 10% distribution. This means 60% of the time the fund does not earn enough to pay out its 10% "dividend". This 10% yield is an optical illusion , and while completely legal it is one aspect of the fund industry that requires more investor attention.

Share Dilution

The fund will issue new shares to investors instead of cash distribution. Given that in many years this distribution was lower than earnings (dividends and capital gains) the fund was required to return capital to investors. This means investors may have been paid in shares with their own initial capital. I inspected the fund's financial statements from 1995 to the present and found that the total shares increased by 2.5x while EPS was lower than DPS in 13 of 28 years.

Portfolio Overview

When analyzing a fund, I usually delve deep into its portfolio to assess its potential for growth, risks, valuation, and upside. I reviewed the USA fund, and based on consensus estimates of 37 stocks, which account for approximately 50% of the current AUM, I found that it has a low upside potential of 5% and a negligible dividend yield. However, the fund appears to have a more value-driven portfolio despite its larger tech positions and a PEG ratio of 1x is a positive sign. My bottom-up analysis suggests that the fund may have difficulty in reaching its 10% distribution requirement in 2024 with its current portfolio.

Currently, the five all-star asset managers have a 60% tilt towards value investing, which may not be sufficient to achieve or exceed the 10% distribution policy.

Conclusion

I rate USA a Sell. The fund's 10% distribution policy is a structural hindrance to long-term performance since any capital gain shortfall will be made up from the return of capital that further dilutes shares. The all-star fund management strategy that mixes value and growth does not seem to work well under this required distribution policy.

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