The Noise In CEF Premium Discount Analysis
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