Strategy Session: Discounted Closed End Funds

James Pope |

DIS and DAT - Strategy Session: Discounted Closed End Funds

“Whether socks or stocks, I like buying quality merchandise when it is marked down.”
~Warren Buffett

            All right we are going to get a little geeky. We can here the responses now, “Aren’t you always?” In this report, we will explain one of several investment strategies DIS blends together in constructing a client’s portfolio.

In our May 2012 DIS and DAT (seen here), we outlined our Investment Philosophy and broke down the investment portion of one’s portfolio into 3 general categories: Timed Event, Non-specific event and long term value extraction. We define the Non-specific event category as strategy involving an underpriced asset yet an unknown future event will likely be necessary to provide liquidity of the position. The event could be brought about by management decisions internally to liquidate assets, or it may involve an outside event.

             In this category, one of the tools we use is Closed-End Funds (CEF). We will describe what a Closed-End Fund is, the characteristics we look for, the risks associated, and how it may fit in one’s portfolio.

            A Closed-End Fund is a managed fund that issues a fixed number of shares in an IPO and is publicly traded in the secondary market on stock exchanges. Unlike Open-End Funds (i.e. Mutual Funds), Closed-End Funds trade throughout the day based on market price as determined by current supply and demand. This leads CEFs to usually trade at a premium or discount to underlying Net Asset Value or N.A.V. An individual CEF’s underlying assets may derive from a variety asset classes such as U.S. Equity, Muni’s, U.S. Bonds, Global and International, Sector and Specialty Funds, as well as Single Country Funds. CEFs can also use leverage within the fund, something that is unavailable in Open-End Funds.

           Closed-End Funds fall into the aforementioned investment category for two reasons. One is the cash flow distributed from the fund and the other is an expectation that we can sell the CEF when/if the discount shrinks to a point where the position is no longer worth holding. We categorize this investment strategy into a 12-36-month time frame of one’s portfolio, but could be longer or shorter based on other factors.

            When reviewing a Closed-End Fund for a potential investment, there are many factors we research before purchase other than just looking for highest discount:

  • Premium/Discount- Obviously as value-minded investors, paying a premium for underlying assets is what we like to avoid. All discounts are not created equally though. Some funds historically trade at deep discounts while others normally trade at premiums. To get a better idea of the current discount, we look at the 5- and 10-year history to see where it is trading in relation to its historical norms.                                                                                       
  • Asset Class/Fund Holdings- If Asset Class/Fund Holdings are overvalued; a discount alone may not be enough to save you from possible losses.
  • Yield- What is the current yield on fund assets? How much is the fund paying out? If the fund’s payout is higher than the income produced by the underlying assets, is it capital gains? Return of principal? Understanding where the distribution is coming from gives us a better idea of how long the discount may persist.
  • Management Fees/Expense Ratio- Are the management fees reasonable?
  • Leveraged Assets- Over-levered funds can lead to principal loss. We may require a higher discount then non leveraged funds.
  • Total Fund Assets- Smaller funds might be illiquid, leading to wider bid/ask spread causing higher transaction expenses on entry and exit.
  • Fund Manager- How long have they been managing fund? Does the current manager own any shares?

Investment theory states there are 2 basic types of investment risk, systematic and unsystematic risk. Systematic risk is defined as market risk, or inherent macro-economic risks associated with investing. Unsystematic risk is defined as specific risk related to an individual security. With the discounted closed end fund strategy, the systematic risk is dependent on the underlying asset class.

            With the variety of asset classes, the unsystematic risks in closed end funds will vary but there is a couple of risks that can be common with the tool itself. These are liquidity risk and leverage risk.  Liquidity risk, by definition, is the risk a security cannot be traded quickly enough in the market without impacting market price. With this comes wider bid-ask spreads that lead to higher transaction costs. Also, in a time of market distress, the lack of liquidity can lead to large price swings due to lack of buyers. Leverage risk is the risk that the cost of the leverage capital exceeds the returns on the fund assets. While leverage can enhance returns, it also has the same magnifying effect as assets decline in price.

In conclusion, we know investing can be emotional, especially when the investor’s sole focus is on price. Our objective is that by sharing how an investment may fit into your overall portfolio regarding strategies, philosophy, and associated risks, it will lead to fewer detrimental emotional reactions.

We appreciate your time and will talk to you again soon,

Reggie McFadden, CFA 


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