By Joe Eqcome:
Closed-end funds are unique in their indigenous nature of being
able to provide investors contemporaneous and observable
market-based rates of return for both stocks and underlying asset
portfolios. All things being equal, CEF share prices should closely
track the underlying net asset value ((
NAV
)) less a discount for the CEF's expense ratio. Yet, this has not
historically been the case.
Tower of Babel:
I will not attempt to regurgitate the substantial academic
literature, replete with obscure formulas provided to impress
colleagues, but will attempt to provide some practical observations
from the "dirty fingernails" of people currently working in the
"field".
Up, Down & Sideways:
We've looked at CEF's premium/discount as an analytical tool for
predicting CEF stock price behavior from a number of different
angles including: absolute, relative premium/discounts, price/NAV
spreads, rolling discounts, z-scores, etc.
Conclusion:
Let me state our conclusion up-front, which most will find
unsatisfying and likely to appear self-serving:
1. CEFs' premium/discounts are an important tool in culling out
opportunities. However, there are no magical mechanical trading
rules in consistently picking winners. If there were, they would be
arbitraged away.
2. To generate superior returns based on this premium/discount
information requires a working knowledge of the CEF market sector
as well as some familiarity with the CEFs in question.
Why?
Our observation is that the premium/discount calculation contains a
lot of "noise". The bulk of this "noise" comes from the following
sources:
1.
Timeliness and Accuracy of NAVs.
In addition to some CEFs doing less frequent updates of their NAVs,
you have the issue of accuracy as it relates to assets that are
indirectly valued at Level II and model-driven at Level III.
2.
Tax Liabilities.
The nature of the imputed tax liabilities of distributions and the
tax-basis of assets ultimately impacts net returns to
investors.
3.
Sector Momentum.
The CEF stocks may anticipate a trend, e.g., commodity prices
rising, and the share prices will move ahead of the respective NAV.
This also works on the downside-this is what we experienced with
the buy/write option CEFs' spreads widening prior to the
distribution collapse.
4.
CEF Trading Liquidity.
Some share prices can become distorted due to large temporary
volume changes as dominant investors enter or exit a particular
CEF.
5.
Leverage:
Most CEFs employ debt to enhance return which may impact the NAV
depending on the trends in debt costs and amount leveraged.
6.
Uninformed Investors.
CEFs investors are predominately retail investors. These retail
investors are mostly seeking income and are attracted to high
distribution yields. Sometimes these distributions may not be
supported by the on-going earnings capacity of the CEF. These
distributions may be supported by a component of return-of-capital
which dissipates its NAV while "jacking up" its yield and its
premium-the entire aforementioned notion is not supported by
investment logic.
7.
Franchise Factors:
Most CEFs are advised by large investment management companies with
which investors may feel more comfortable. Pimco is one CEF advisor
for which investors seem willing to pay a premium to own their
advised CEFs.
8.
Managements' Track Record:
Most investors look at the past performance of the CEFs track
record and want to own the one that has historically performed
well. ("Past performance is no indication of future performance-and
in many cases a contrarian indicator.")
9.
Inherent Adverse Selection of IPO Asset Classes.
When asset classes become popular, i.e., valuation rising and
becoming part of the popular press, this is the time that CEF
sponsors will roll-out new funds to capture new dollars. These CEFs
almost immediately go to a discount.
So, these are some of the things that can distort the value of
the premium/discount relationship. I'm sure there are more to add
to this list.
Why Bother:
However, having said that, we have found an inherent bias-both
short-term and long-term-towards certain types of premium/discount
configurations for different data sets that are relatively good
screens for identifying mispriced CEFs.
Short-Term:
For example, we found that on average the CEF with the largest
negative spread has a tendency (but not absolutely) to outperform
the CEFs with the largest positive spread on a weekly and bi-weekly
basis. This was true in terms of frequency of "beats" but also on a
relative returns basis. However, the margin of return was fairly
narrow after trading costs. The ability to sort through the
potential underlying reasons for the change further enhances
returns. (See, "
CEF Week
" series of articles)
Longer-Term:
On a longer term basis, we published a report at the beginning of
2009 entitled,
"
CEF Premium/Discount
"Mean Gravitation" Provides Opportunities".
We looked at the five largest relative discounts to their
historical spread. The average capital appreciation currently has
been 60% versus 34% for the CEF fund sector since the report was
issued. However, this required a three year holding period.
The
CEFDogs™
strategy, buying the worst performing CEFs in the previous year
with the expectations that they'll outperform in the subsequent
year, has had some mixed results over the past three years. (See,
CEFDogs11
)
Rolling Discounts:
We've also looked at this issue from a rolling monthly and
quarterly spreads perspective and found that those CEFs with large
relative changes in their relative premium/discount can be a
function of an adverse corporate event, a distribution cut, or a
change in investor or asset class momentum. In this case, the
significant deviation from the mean reflected a durable change in
valuation.
Working Knowledge Helps:
So, while there is a tendency for premium/discount mean conversion,
it's not absolute. In order to generate superior returns based on
this information, it requires a working knowledge of the CEF market
sector as well as some familiarity with the CEFs in question.
I know this sounds self-serving, but it is the facts that fall
out of the numbers.
Disclosure:
I'm long stock in the CEFDogs11 (See hyperlink in article for
stocks included in the portfolio and I'm long TF, IIF, IFN,
CAF.)
See also
Transgenomic: Q4 Results Beat On Top And Bottom
on seekingalpha.com