Cross A Greater Fool Trade With A Ponzi Scheme And You Get…

You can feel the exasperation in Jason Zweig’s post from a few days ago, titled “High Rates?  Are You Delirious?” (emphasis mine)

“Have today’s insanely low interest rates driven investors insane?

Three closed-end funds offered by Cornerstone Advisors of Asheville, N.C., show that some investors have come to believe the impossible: that high yields can persist in a world where central banks have squashed down bond rates to next to nothing.

These people have deluded themselves into believing they are earning fat yields. In reality, they merely are getting their own money back—and you can’t turn a fantasy into fact just by wishing it were so.

At Cornerstone, investors are receiving “distribution yields” of roughly 22% of net asset value, and the shares trade for much more than the value of their underlying assets. According to the WSJ Market Data Group, the Cornerstone funds are the three highest-yielding of the 657 closed-end funds in the U.S.

Most of the yield at Cornerstone, however, doesn’t come from its investments. In past years, it came from giving investors some of their original assets back. Now, it comes out of money the funds’ investors have just added.”

This is the first I’ve heard of these Cornerstone funds, but this has been going on, and people have apparently been writing about it, for years.

Just in case it’s not clear, what these Cornerstone closed end funds are doing is making huge payouts, but not from dividends earned – rather they’re pulling the old Teddy KGB and “paying you with your money.”   And the “beauty” of it, if you can use that word to describe this sad exhibition of investor ignorance, is that investors are so drunk on pseudo-yield that they are willing to pay a huge premium to net asset value for the funds!  Amazing.

Greater fool trades are abdanunt – we’ve discussed a few on this blog already: some that have blown up (TVIX) and some that have only partially blown up (GAZ).  I actually have a greater fool trade on myself right now that I haven’t yet written about and may not write about, because frankly I don’t want everyone looking at this trade yet, but the bottom line is that I’m betting on some investor stupidity.   This Cornerstone trade is a whole new ballgame though – the Ponzi reference is not an overstatement:  they will use the newly raised funds from the rights offering to continue to make these large payouts.

Now, to be fair to Cornerstone, they aren’t exactly hiding the truth here, they tell you straight up:

“It should be noted that the distributions made pursuant to this policy are not tied to the Fund’s investment income or capital gains and do not represent yield or investment return on the Fund’s portfolio….

Under the distribution policy, the Fund’s distributions will consist either of (1) earnings, (2) capital gains, or (3) return-of-capital, also known as paid-in-capital, or some combination of one or more of the above. A return-of-capital is the return of a portion of the investor’s original investment. Given the current economic environment and the composition of the Fund’s portfolio, a substantial portion of the Fund’s distributions made during the current calendar year is expected to consist principally of a return of the investor’s capital. Accordingly, these distributions should not be confused with yield or investment return on the Fund’s portfolio. The final composition of the distributions for 2011 cannot be determined until after the end of the year and is subject to change depending on market conditions during the year and the magnitude of income and realized gains for the year.

In any given year, there can be no guarantee that the Fund’s investment returns will exceed the amount of the net distributions. To the extent that the amount of distributions taken in cash exceeds the total net investment returns of the Fund, the assets of the Fund will decline.”

How about a fantastically fun game of hot potato?  Check this out – the Fund has an automatic dividend reinvestment program:

“As revised, the plan provides that, effective November 1, 2011, the method for determining the number of newly issued shares received when distributions are reinvested will be determined by dividing the amount of the distribution either by the Fund’s last reported net asset value per share or by a price equal to the average closing price of the Fund over the five trading days preceding the payment date of the distribution, whichever is lower. “

Translation – when the Fund is trading at a premium to NAV, you get your distribution shares at NAV… So you can either sell them at the higher price and reap the benefit, or try to leverage up and catch another distribution-reinvestment-at-a-discount-to-market-price windfall the next month!  Talk about an interesting case of “don’t get caught holding the grenade with the pin pulled” game theory!

I hope this doesn’t apply to any of my readers, but I’m sure there will be people out there who don’t get what’s wrong with the setup here.  Check that – it’s obviously a fact that there are people out there in this mindset, or the funds wouldn’t trade at a premium.   Let me try an analogy.   I am going to open a closed end fund.  I will sell 1MM shares for $10 each.  Now my fund will have $ 10MM which I will invest.  However, I will pay out $2 in annual distributions regardless of how my investments do.   Does that make sense?  Are you happy to just receive distributions?  Why?  In order to pay the $2, I have to sell the investment that I bought with your money, just to give the money back to you.  It’s your money that I’m giving back to you, not investment income (largely:  the details are in the SEC filings, and Zweig summarizes some of them).

$CFP’s holdings, by the way, are listed in this filing – they hold a number of different positions, largely in other closed end funds.

Zweig’s piece sums it up without pulling punches:

“Investing has sunk to this: People are willing to pay a big premium for the privilege of getting their own money back, after fat fees, without interest—apparently because it gives them the illusion of earning a high yield.

Desperate people do desperate things. Investors who are starved for yield do desperately stupid things.”


Zweig: “High Rates, Are You Delirious?


disclosure: no positions in $CFP

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