ZTR: Much Improved Portfolio And May Benefit From AI Boom

seekingalpha08-06

Virtus Total Return Fund Inc. is a closed-end fund that can protect against inflation and generate income.The ZTR fund's current yield of 10.33% compares well with similar funds, but its performance ...

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Monty Rakusen The Virtus Total Return Fund Inc. (NYSE:ZTR) is a closed-end fund, or CEF, that investors can employ as a method of protecting their wealth against the adverse impacts of inflation and generating an income at the same time. As I have explained in a few previous articles, I doubt that the United States will ever return to a “zero-inflation” environment as we became accustomed to during the decade before the COVID-19 pandemic. The fiscal demands on the Federal government are simply too great today, and it is almost certain that it will be forced to resort to debt monetization at some point. Thus, it is a good idea for investors to have some means of protecting their assets against the loss of purchasing power that will inevitably result from such an event. The Virtus Total Return Fund does manage to do fairly well in terms of income, as its 10.33% current yield compares pretty well with other closed-end funds that employ a similar strategy. This can be clearly seen here:   Fund Name Morningstar Classification Current Yield   Virtus Total Return Fund Hybrid-Global Allocation 10.33%   Calamos Global Dynamic Income Fund (CHW) Hybrid-Global Allocation 8.94%   Clough Global Opportunities Fund (GLO) Hybrid-Global Allocation 11.18%   Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund (ETO) Hybrid-Global Allocation 8.41%   Guggenheim Active Allocation Fund (GUG) Hybrid-Global Allocation 9.22%   LMP Capital and Income Fund (SCD) Hybrid-Global Allocation 8.88%   Click to enlarge As we can see, the Virtus Total Return Fund has a significantly higher yield than most of the other funds in its category. This might be concerning, as an outsized yield is generally considered to be a sign that the market does not believe that the fund will be able to sustain its current distribution. However, it is important to note that some of these funds use entirely unique strategies. For example, the Guggenheim Active Allocation Fund is very bond-heavy, while the LMP Capital and Income Fund is almost entirely invested in common stocks. The asset allocation of a given fund will have a significant impact on the income that it can earn, and thus the yield that it can pay out. As such, it is possible that not all of these funds will be completely comparable. As regular readers may remember, we previously discussed the Virtus Total Return Fund in early December 2023. The market since that time has been mixed, as equities have performed well, but bonds mostly have not. Domestic bonds in particular have declined since the start of this year as the markets realized that expectations of significant interest rate cuts in 2024 were far too optimistic. The Virtus Total Return Fund can invest in both equities and bonds, so it is difficult to make assumptions about its performance on those grounds. However, most closed-end funds have appreciated since early December, so we can probably expect that this fund has at least experienced some share price gains. This assumption turns out to be correct, as shares of the Virtus Total Return Fund have appreciated by 7.20% since the publication date of my previous article on this fund:   Seeking Alpha A 7.20% gain over nine months is not at all bad, as that is very close to the historical average gain of the equity markets over the same time. However, at the same time, the Virtus Total Return Fund underperformed both the S&P 500 Index (SP500) and the MSCI World Index (URTH) by a considerable margin. Thus, while the fund’s performance would have been acceptable in most market environments, many investors will likely find it to be very disappointing right now. This is due to the simple fact that nobody like to underperform the market indices by such a large degree. However, as I stated in a recent article: A simple look at a closed-end fund’s price performance does not necessarily provide an accurate picture of how investors in the fund did during a given period. This is because these funds tend to pay out all of their net investment profits to the shareholders, rather than relying on the capital appreciation of their share price to provide a return. This is the reason why the yields of these funds tend to be much higher than the yield of index funds or most other market assets. This is important for funds such as the Virtus Total Return Fund, which provide a significant proportion of their total investment return in the form of direct payments to their shareholders. When we include the distributions that this fund paid out over the past nine months, we get a very different picture of its relative performance:   Seeking Alpha As we can see here, the Virtus Total Return Fund actually managed to outperform the MSCI World Index over the past nine months when measured on a total return basis. However, it took the fund until August to do so. The fund still underperformed the S&P 500 Index over the period, however. In this light, though, the fund’s relative performance might not be completely unacceptable to all investors, as income-focused investors are sometimes willing to accept a lower return if it nets them a higher income. The fund’s total return performance might be close enough to the indices to be acceptable to these investors. As nine months have passed since we last discussed this fund, it would be logical to assume that many things have changed. In particular, the fund has released an updated financial report that will be helpful in determining how sustainable its distribution is likely to be. This article will focus specifically on these changes, as well as provide an updated analysis of its distribution sustainability. About The Fund According to the fund’s website, the Virtus Total Return Fund has the primary objective of providing its investors with capital appreciation. This is a very unusual objective for a closed-end fund, although it does make a certain amount of sense if the fund is focused on investing in the equity markets. Here is how the website describes its strategy:  The Fund’s investment objective is capital appreciation, with current income as a secondary objective. The Fund seeks to meet its objectives through a combination of equity and fixed income investments. The equity portion of the Fund invests globally in owners/operators of infrastructure in the communications, utility, transportation, and energy industries. The fixed income portion of the Fund is designed to generate high current income and total return through the application of active sector rotation, extensive credit research, and disciplined risk management designed to capitalize on opportunities across under valued areas of the fixed income markets.  This is a different objective than we may have expected to find, and it is certainly an unusual one if the fund’s primary objective is capital appreciation. In short, the fund appears to be an equity infrastructure fund combined with a bond fund. Infrastructure in general has not been particularly good at producing capital gains recently. The S&P Global Infrastructure Index, which is tracked by the SPDR S&P Global Infrastructure ETF (GII), has gained 16.27% over the past ten years. That only works out to 1.6% per year on average, and it was substantially worse than the 176.79% gain of the S&P 500 Index over the same period:   Seeking Alpha Even if we look at it from a total return basis (including dividends and distributions), the S&P Global Infrastructure Index only returned 58.90% over the trailing ten-year period. Utilities managed to do somewhat better, with the U.S. Utilities Index (IDU) delivering a 143.78% total return and the Global Utilities Index (JXI) delivering a 91.24% total return over the trailing ten-year period. However, both of these still underperformed the S&P 500 Index by quite a lot. The inclusion of fixed-income securities in a fund primarily targeting capital gains is a very odd choice. As I stated in a previous article: Bonds by their very nature are income securities, as they do not deliver any net capital gains over their lifetimes. This makes sense, as an investor will purchase a bond at face value and receive face value back when the bond matures. The only investment return for a bond held over its entire lifetime is the coupon payments made to the bond’s owner. Thus, bonds do not deliver capital appreciation over their lifetimes. While it is possible to receive capital gains from bonds by trading them before maturity, that usually requires interest rates to be declining. While we are starting to see some foreign central banks reduce their benchmark rates, this has not yet been the case in the United States. In fact, both domestic and global bond prices have been range-bound for most of the past three years. We can see this here:   Seeking Alpha For the purposes of constructing this chart, I used the iShares U.S. Core U.S. Aggregate Bond ETF (AGG) and the Vanguard World Bond ETF (BNDW) as proxies for the domestic and global bond markets, respectively. Admittedly, the Vanguard World Bond ETF is not the best proxy for the global bond market. This is because it significantly overweights the United States compared to its actual representation in the global bond market, but it is currently the only index exchange-traded fund tracking the sector. In any case, we can still see that the bond markets have been range-bound and capital gains have been difficult to come by compared to equities. Thus, if the Virtus Total Return Fund is targeting capital appreciation as a primary objective, it would make sense for it to be much more heavily weighted to common stocks than to bonds. This is indeed the case, as the fund’s semi-annual report states that it had the following asset allocation on May 31, 2024:   ZTR Semi-Annual Report We can see here that the fund had 74% of its assets invested in common stocks at the end of May 2024. Thus, it appears that the fund’s management agrees that common stocks are far better for capital gains right now than common stocks. The allocations between utilities, industrials, and energy infrastructure stocks have changed fairly significantly since the last time that we discussed the fund. In the previous article, I shared this chart showing how the fund’s equity allocation was divided up:   Virtus Here is the same chart using today’s holdings data:   Virtus We notice that the fund’s utility sector holdings decreased by 2.82% over the period in question. The fund’s real estate and communications weightings also decreased, albeit by slightly lesser degrees. The decrease in the utilities, real estate, and communications sectors was offset by increases in both industrial and energy infrastructure holdings. This is actually not a bad change, as it makes the fund’s holdings between its three primary sectors somewhat more balanced than they were previously. However, the fund still maintains some considerable exposure to the utility sector. The large utility sector weighting might not be a bad thing, despite the negative press that the sector received back in 2023. The U.S. Utilities Index is up 18.45% year-to-date, but the Global Utilities Index is only up 2.14% year-to-date:   Seeking Alpha This is despite the poor year-to-date performance of bonds, which may be surprising as the utility sector is frequently considered to trade similarly to bonds. Indeed, Yahoo! Finance ran an article several years back showing that utility share prices and bond prices exhibit a high correlation. Today, however, the utility sector appears to be caught up in the artificial intelligence bubble. As I explained in a recent article, electric utilities in particular will almost certainly benefit from the wide scale deployment of generative artificial intelligence. This is due to the substantial electricity consumption of servers running the processors necessary to make the technology work. From my article: Researchers have been raising general alarms about AI’s hefty energy requirements over the past few months. But a peer-reviewed analysis published this week in Joule is one of the first to quantify the demand that is quickly materializing. A continuation of the current trends in AI capacity and adoption is set to lead to NVIDIA shipping 1.5 million AI server units per year by 2027. These 1.5 million servers, running at full capacity, would consume at least 85.4 terawatt-hours of electricity annually – more than what many small countries use in a year, according to the new assessment. I will admit that I highly doubt that generative artificial intelligence will live up to the hype that is currently surrounding it. In particular, some analysts are predicting that artificial intelligence will be able to replace tens of millions of human workers. This will make it impossible to sustain a consumer-driven economy, as there is no alternative source of employment for all of these displaced workers. However, this does not mean that technology companies will not buy the servers and construct the data centers required for the artificial intelligence dream, so electric utilities will still benefit. As such, it could make sense for the fund to have a reasonably large exposure to the utility sector. Leverage As is the case with most closed-end funds, the Virtus Total Return Fund employs leverage as a method of boosting the capital gains and yield that it receives from the assets in its portfolio. I explained how this works in my previous article on this fund:  Basically, the fund borrows money and then uses that borrowed money to purchase the common stock of utilities and other infrastructure companies, as well as corporate bonds. As long as the total return that it receives from the purchased assets is higher than the interest rate that the fund has to pay on the borrowed money, then the strategy works pretty well to boost the effective return that it receives from its portfolio. As this fund is capable of borrowing money at institutional rates, which are considerably lower than retail rates, this will usually be the case. However, the use of debt in this fashion is a double-edged sword. This is because leverage boosts both gains and losses. As such, we want to ensure that the fund is not employing too much debt because that would expose us to an excessive amount of risk. I normally would like to see a fund’s leverage remain under a third as a percentage of its assets for this reason.  As of the time of writing, the Virtus Total Return Fund has leveraged assets comprising 30.63% of its overall portfolio. This represents a marked decrease over the 32.25% leverage that the fund had the last time that we discussed it. This should perhaps not come as a real surprise, given the share price appreciation that the fund has delivered over the past nine months. The fund’s portfolio has increased in size along with its share price. As we can see here, the Virtus Total Return Fund’s net asset value has increased by 5.24% since the date of my previous article’s publication:   Barchart Thus, it is logical that the fund’s leverage ratio will have decreased over the period. After all, the same level of leverage would now represent a smaller percentage of a larger portfolio. The Virtus Total Return Fund currently has a leverage ratio that is below the one-third maximum level that we would ordinarily prefer to see in any closed-end fund. However, that does not necessarily mean that its leverage is at a safe level from a risk management perspective. So, let us compare this fund’s leverage ratio with its peers:   Fund Name Leverage Ratio   Virtus Total Return Fund 30.63%   Calamos Global Dynamic Income Fund 31.83%   Clough Global Opportunities Fund 30.48%   Eaton Vance Tax-Advantaged Global Dividend Opportunities Fund 19.12%   Guggenheim Active Allocation Fund 25.25%   LMP Capital and Income Fund 19.06%   Click to enlarge (all figures from CEF Data.) As we can see, the Virtus Total Return Fund has a higher level of leverage than some other funds in its category. However, it does not appear to be completely out of line with its peers, as there are two other funds with a very comparable level of leverage. As such, it does not appear that the Virtus Total Return Fund is excessively leveraged right now. I will admit that I would prefer it to have a somewhat lower level of leverage than it currently possesses to bring its risk level down in line with some “safer” funds in the sector, though. Distribution Analysis The primary objective of the Virtus Total Return Fund is to provide its investors with a high level of capital gains. As is the case with most closed-end funds, it aims to pay out most or all of its capital gains via regular distributions to its shareholders. To this end, the fund pays a monthly distribution of $0.05 per share ($0.60 per share annually). This gives the fund a yield of 10.33% at the current share price, which is a bit higher than many of its peers. Unfortunately, the fund’s distribution has not been especially consistent over the years. We can see this clearly here:   CEF Connect From the previous article: The fund’s history was actually pretty reasonable over most of the last decade. As we can see, it generally was able to increase its payout from the period extending from the 2009 recession to the outbreak of the COVID-19 pandemic. Its more recent history has not been particularly encouraging, however. That will probably be something of a turn-off for any investor who is seeking to earn a safe and secure income from the assets in their portfolios. Let us take a look at the fund’s finances to see how well it can sustain its current distribution going forward. After all, that is far more important to any potential buyer today than the fund’s past performance. As of the time of writing, the most recent financial report that is available for the Virtus Total Return Fund is the semi-annual report for the six-month period that ended on May 31, 2024. A link to this report was provided earlier in this article. As is probably pretty obvious, this is a much newer report than the one that was available to us the last time that we discussed this fund. So, it should work pretty well to provide an update on the fund’s performance. For the six-month period that ended on May 31, 2024, the Virtus Total Return Fund received $8.795 million in dividends along with $5.204 million in interest from the assets in its portfolio. From this amount, we subtract the amount that the fund had to pay in foreign withholding taxes to arrive at a total investment income of $13.440 million for the period. The fund paid its expenses out of this amount, which left $4.342 million available to shareholders. That was not sufficient to cover the $20.230 million that the fund paid out to its investors in distributions over the period. Fortunately, the fund was able to make up the difference through capital gains. For the six-month period that ended on May 31, 2024, the Virtus Total Return Fund reported net realized gains of $1.494 million and had an additional $17.748 million in net unrealized gains. That was enough to cover the distributions, with $3.354 million left over. Thus, the fund did technically manage to cover its distributions during the period. Its net assets still declined by $37.777 million overall, though, but that was due to a share tender offer that cost the fund $41.131 million. In the absence of this tender offer, the fund’s net assets would have increased over the period. Thus, we probably do not need to worry too much about the distribution’s sustainability right now. Valuation Shares of the Virtus Total Return Fund are trading at a 14.33% discount to net asset value as of the time of writing. This is a substantially more attractive price than the 11.73% discount that the shares of the fund have averaged over the past month. However, investors should keep in mind that it is very likely that the net asset value of the fund declined sharply on August 5 due to the size of the market sell-off. As such, the discount at the time that this article is seen or read might actually be smaller than the calculated amount. Conclusion In conclusion, the Virtus Total Return Fund appears to have improved since the last time that we discussed it. In particular, the fund’s portfolio is no longer hemorrhaging money and, in fact, it appears to be benefiting from the bubble in artificial intelligence that has been going on for a while now. This is a very nice thing to see, as it has apparently resulted in the fund fully covering the distribution during the first half of its fiscal year.  As readers may recall, the last time that we discussed this fund I was concerned about the distribution’s sustainability, so it is impressive to see that this problem has been resolved. The fund also typically trades at a pretty large discount to net asset value, so that is also nice. The real downside with Virtus Total Return Fund Inc. is that the fund’s share price performance tends to lag the indices, but that is true of most closed-end funds.","kind":"highlight","is_publish_news":true,"is_publish_highlight":false,"is_publish_live":false,"is_publish_wemedia":null,"editions":null,"column":"","sentiment":"0","news_tag":"","news_rank":0,"symbols":[],"gpt_button":1},"commentList":[],"isCommentEnd":true,"newsSizeData":{"likeSize":0,"commentSize":0,"repostSize":0,"favoriteSize":0,"likeStatus":false,"favoriteStatus":false},"APP":{"userAgent":"Mozilla/5.0 AppleWebKit/537.36 (KHTML, like Gecko; compatible; ClaudeBot/1.0; +claudebot@anthropic.com)","isDev":false,"isTTM":true,"deviceId":"web-server-community-laohu8-v3","version":"4.29.3","shortVersion":"4.29.3","platform":"web","vendor":"web","appName":"ttm","isIOS":false,"isAndroid":false,"isTiger":false,"isTHS":false,"isWeiXin":false,"isWeiXinMini":false,"isWeiBo":false,"isQQ":false,"isBaiduSwan":false,"isBaiduBox":false,"isDingTalk":false,"isToutiao":false,"isOnePlus":false,"isHuaWei":false,"isXiaomi":false,"isXiaomiWebView":false,"isOppo":false,"isVivo":false,"isSamsung":false,"isMobile":false},"href":"/m/news/2457002843"}