What is a Closed-End Fund? A closed-end fund is a publicly traded investment company that invests in a variety of securities, such as stocks and bonds. According to the fund’s investment objectives, the fund raises capital primarily through an initial public offering (IPO). “Closed” refers to the fact that, once the capital is raised, there are typically no more shares available from the fund sponsor and the issuance of new shares is closed to investors. After the IPO, most closed-end funds are listed on a national exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. There the fund’s shares are purchased and sold in transactions with other investors, not with the sponsor company itself. The typical closed-end fund strategy represents an actively managed selection of holdings. These investments in securities collectively add up to a value, known as its Net Asset Value (NAV), that may be different from the fund’s market price. The market price is determined by market demand and supply, not the fund’s net asset value. Since most closed-end funds offer regular monthly or quarterly distributions, demand is often related to both the distribution amount and the NAV performance of a fund. Although the outstanding shares of a closed-end fund remain relatively constant, additional shares can be created through secondary offerings, rights offerings or the issuance of shares for dividend reinvestment. Key Considerations for Closed-End Funds Closed-end funds are investments designed for income-conscious investors seeking to meet a wide range of investment goals, including: The potential to meet current obligations with monthly or quarterly cash flow; The potential to achieve attractive, long-term total returns; The opportunity to realize greater income portfolio diversification. Closed-end fund shares also carry risks investors should understand: Closed-end funds trade on exchanges at prices that may be more or less than their NAVs. There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price. Closed-end funds often use leverage, which increases a fund’s risk or volatility. There are several characteristics of closed-end funds that can help investors meet their investment goals: Portfolio Management – The asset base for closed-end funds is relatively stable. Without the pressure of constantly investing or redeeming securities based on investor demands, closed-end funds may be able to take better advantage of a wide variety of investment strategies, including longer-term and less liquid securities or markets. Distributions – Closed-end funds are generally designed for regular cash flow. Distributions are paid according to a prescribed schedule — typically monthly or quarterly — which allows investors to plan the timing of this income. Of course, the actual amount of the distributions may vary with fund performance and market conditions. Leverage – Closed-end funds often borrow capital or issue preferred shares in order to leverage their portfolios. The goal is to use the additional capital to invest for a return that exceeds the cost of the leverage. Any excess return, or loss, is added to the return on capital raised through common shares. Thus, leverage multiplies both potential return and the volatility of the fund’s portfolio. . Market Pricing – Investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund – rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of closed-end funds. Trading Liquidity and Flexibility – A stock market listing means that closed-end fund shares may be bought or sold at any time during the trading day, and the price is updated throughout the trading day, not just at the close. Like other investments, share prices will fluctuate with the market, and may be worth more or less at the time of sale than the original purchase price. Expenses – Closed-end funds typically do not impose annual 12b-1 fees. However, investors must still pay a brokerage commission to purchase and sell shares for all closed-end funds. For those investors who trade frequently, this can significantly increase the cost of investing in closed-end funds. This means closed-end funds may have lower expenses internally, but an investor’s total costs may not be lower.
Understanding Leverage in a CEF What Is Leverage? Leverage simply means that an investment portfolio is larger than its net asset base. The fund raises additional capital through a debt issuance, a preferred share issuance, or by using sophisticated financial products to increase the value of its underlying portfolio. Say, for example, a fund has net assets of $500 million, raised in an initial public offering of 50 million common shares. It then issues $250 million of preferred shares. Total capital is then $750 million. Common shares outstanding are 50 million. Total capital per share is $15.00 Net asset value per share = (Total Capital – Liabilities (preferred shares)) ÷ Shares Outstanding = ($750 million – $250 million) ÷ 50 million = $500 million ÷ 50 million = $10.00 This CEF has a leverage ratio of 50%, computed as capital from preferred shares divided by net asset value: $5 from preferred shares ÷ $10 in net asset value = 50% Leverage magnifies returns, both positively and negatively. In other words, a leveraged fund exhibits more volatility than would an unleveraged fund investing in the same securities. Why Can CEFs Use Leverage? Because of their closed-end structure, CEFs are allowed by law to use leverage. Specifically, according to the Investment Company Act of 1940–which provides the framework for CEFs, mutual funds, and ETFs–CEFs are allowed to issue: Debt in an amount up to 50% of net assets Preferred shares in an amount up to 100% of net assets In practice, the average leveraged CEF carries 33% total leverage. For every $1.00 of net assets, they have another $0.33 in leveraged capital. Non-’40 Act Leverage Leverage achieved through debt and preferred shares is commonly referred to as “’40 Act Leverage,” after the Investment Company Act of 1940. There are other methods by which a fund can leverage its net assets. This is referred to as “Non-’40 Act Leverage.” Whereas the provisions for leverage within the ’40 Act were meant to safeguard the integrity of a fund’s capital structure, non-’40 Act leverage is unrelated to the capital structure. It arises, instead, from the fund’s portfolio of investments. Examples of non-’40 Act leverage include: Tender option bonds Reverse repurchase agreements Securities lending obligations Transparency Leverage is leverage. Regardless of the source of the leverage, it has the same effects on a portfolio as outlined earlier in this presentation. This is why transparency of a fund’s true leverage is so important. Only ’40 Act leverage is required by law to be reported. All leverage is actually reported on the financial statements, but only ’40 Act leverage needs to be reported as “leverage.” Fund families have wide discretion in how they choose to actively report non-’40 Act leverage. Their websites may say a fund is unleveraged, when it actually has a lot of non-’40 Act leverage. One simple way for investors to check leverage ratios is the following: Total Leverage = Total Assets / Net Assets The closer the value is to 1, the lower the leverage. Morningstar.com shows a CEF’s ’40 Act leverage, non-’40 Act leverage, and total leverage ratios to help investors see what’s really going on. Key Takeaways Adding leverage to a CEF’s portfolio will increase volatility of NAV returns. Adding leverage can also enhance a CEF’s distribution rate. There are costs to adding leverage to a portfolio. While the Investment Company Act of 1940 allows CEFs to issue debt and preferred shares (with certain limitations), CEFs can also use non-’40 Act leverage. Regardless of the source of the leverage, the effects will be the same. In times of extreme market distress, a leveraged fund may be forced to liquidate holdings to meet leverage coverage ratios. In such rare cases, the benefits of the closed-end structure eviscerate, and the capital is permanently impaired. In 2008 and 2009, this happened to a few leveraged high-yield (“junk bond”) CEFs. While many investors are rightfully cautious about leverage, it’s important to understand that the average leveraged CEF is only 33% leveraged.
CEF Discounts and Premiums (information from Morningstar.com’s CEF section) CEFs have an underlying portfolio of securities. From this portfolio, a net asset value (NAV) can be derived. NAV = (assets – liabilities) / shares outstanding the investment portfolio primarily, if not solely, comprises the assets. For leveraged CEFs, the leverage itself is the bulk of the liabilities. CEFs trade on an exchange. This means that they have a share price, which is set by the market. These two prices, the NAV and the share price, are rarely the same, and when they are, it’s only by coincidence. The differences between the share price and the NAV create discounts and premiums. Shares are said to trade at a “discount” when the share price is lower than the NAV. The discount is commonly denoted with a minus (“-“) sign. Shares are said to trade at a “premium” when the share price is higher than the NAV. The premium is commonly denoted with a plus (“+”) sign. The calculation is (Share price ÷ NAV) – 1. Examples: Share price = $19.00 NAV = $20.00 Discount = ($19.00 ÷ $20.00) – 1 = 0.95 – 1 = -0.05 = -5.0% Share price = $12.00 NAV = $10.00 Premium = ($12.00 ÷ $10.00) – 1 = 1.20 – 1 = +0.20 = +20.0% What gives rise to discounts and premiums? Why is the market seemingly inefficient? Efficient market hypothesists have tried to explain discounts and premiums for years with myriad explanations. Most commonly, the reason a CEF trades at any given discount or premium is related to the fund’s distribution rate, regardless of the source of the distribution. (Some fund families seemingly abuse the knowledge that this occurs to justify–in their minds, not ours–the use of destructive return of capital.) Other typical reasons for premiums and discounts include: Overall market volatility Recent NAV and share price performance Brand recognition of fund family Name recognition (or lack thereof) of the fund manager Recent changes in distribution policy An asset class or investment strategy falling out of market favor An asset class or investment strategy rising in the market’s esteem Whatever the reason for a CEF’s discount or premium pricing, it is crucial that CEF investors realize that discounts and premiums exist. At Morningstar, when comparing a share price with a NAV, we often refer to discounts and premiums as “Absolute Discounts” and “Absolute Premiums.” We do this because, as discussed in another Solution Center presentation, there are other ways to look at discounts and premiums. For instance, if we compare a CEF’s discount to its average historic discount, this is what we refer to as a “Relative Discount.” Most long-term investors just look at Absolute Discounts and Absolute Premiums. But when considering valuation, it’s important to look at Relative Discounts and Relative Premiums. There are three things to consider regarding discounts and premiums: Regardless of the discount or premium, what matters to an investor is the share price at the time of purchase and the subsequent total return of the CEF. A CEF’s discount or premium tends to persist. If the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate actions from the board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe’s average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount. Over a complete market cycle, most CEF share prices will trade below, at, and above their corresponding NAVs. Absolute Discounts The standard thinking for CEFs is to focus on funds trading at discounts and to avoid funds trading at premiums. We think this maxim is simplistic and could lead to unrealistic expectations for investors. All that matters for a CEF investor is the share price at which the CEF was purchased and the subsequent total return. Discounts and premiums wax and wane over time. For instance, if a CEF is trading at a 15% discount, people often tout this as an opportunity to buy $1.00 of assets for $0.85. The unstated premise is that eventually the price will reach $1.00. This is problematic. Nothing mandates that a share price, even discounted at 15% to NAV, must converge to its NAV over time. Furthermore, the NAV could decline to $0.85 (or lower). We recommend not purchasing CEFs at absolute discounts in the hope that the share price will converge to a higher NAV. The primary benefit of purchasing a CEF at an absolute discount is for income-seeking investors to enhance their yield. “Yield Enhancement” and Absolute Discounts Putting aside sources of distribution, let’s assume that a fund’s underlying portfolio at NAV yields 10%. Distribution = $1.00 per share Net Asset Value = $10.00 per share Distribution Rate at Net Asset Value = $1.00 / $10.00 = 10%. Let’s further assume that the shares trade at a 10% absolute discount. Net Asset Value = $10.00 per share Share Price = $9.00 per share Absolute Discount = (share price – NAV)/NAV = ($9 – $10) / $10 = -10% Because they are buying at a discount, investors purchasing these shares will get a higher yield: Distribution = $1.00 per share Share Price = $9.00 per share Distribution Rate at Share Price = $1.00 / $9.00 = 11.1% So, “Yield Enhancement” = Dist Rate (Share Price) / Dist Rate (NAV) = 11.1% / 10% = 1.1% Buying $1.00 of assets for $0.85 isn’t necessarily a bargain. The table below sets forth the nine scenarios that can play out when purchasing shares at an absolute discount. How the Absolute Discount Can Narrow NAV falls faster than the share price: This is the worst possible scenario. The underlying portfolio is losing value and your shares are worth less. NAV falls and share price remains steady: This is the second-worst scenario, in that the underlying portfolio is losing value. At least your shares haven’t declined in value. NAV falls and share price rises: The investment portfolio is heading south but at least you are making some money. Be careful, though, because ultimately the discount or premium will rely, at least in part, on the portfolio’s performance. NAV is steady and share price rises: This is the scenario implied by investors who say they buy $1.00 for $0.85. NAV rises and share price rises even faster: This is the best of all possible scenarios. Of the nine scenarios, this occurs in only half of one (because the NAV could rise faster than an increasing share price, meaning the discount would widen). Also note the several scenarios where the share price declines or the absolute discount widens. Using absolute discounts as the sole method of finding undervalued CEFs is akin to investing in a value trap. On the flip side, there is no reason to avoid all CEFs trading at an absolute premium. If you are purchasing shares at an absolute premium, you are taking on risk. Your capital could decline, even if the underlying portfolio performs well. This isn’t to say you should never invest at a premium. Most CEF investors have no qualms investing at slight premiums to NAV. But absolute premiums above 10% should really give you pause. The table below shows the nine scenarios that can play out when purchasing shares at an absolute premium. If you find yourself in a situation where the share price is rising and the NAV is declining, you are likely in what Warren Buffett might call a “greater fool” scenario. You may want to consider taking your profits and finding a more suitable investment. Note that only one half of one scenario leads to a rising share price and a narrowing premium. Unwittingly purchasing shares at an absolute premium, only to see the share price decline as the premium narrows, is the number one reason people have a poor experience with CEF investing. Key Takeaways Every CEF has a discount or a premium. It is rare, and short-lived, for a share price to equal the net asset value. Absolute discounts are an inappropriate method of finding undervalued CEFs. When searching for undervalued CEFs, use relative discounts Absolute discounts can and should be sought for “yield enhancement.” Make sure to see our Solution Center presentation on distributions. Absolute premiums should not preclude investment, but they do represent additional investment risk. Extreme premiums above 10% should really give investors pause. Unless the NAV rises to meet your purchase price, even in the long run you will likely lose money on your investment. While there is nothing that mandates a CEF share price equal its net asset value, history shows that funds normally trade at both an absolute discount and an absolute premium over the course of a full market cycle. In other words, the share price does tend to revert toward, and then through, the NAV. Again, when investing in CEFs, discounts and premiums don’t ultimately matter. What matters is your cost basis and the subsequent total return.
CEF’s Relative Premiums & Discounts In truth, all discounts and premiums are relative to another number. Absolute discounts/premiums are relative to the net asset value (NAV). Relative discounts/premiums are relative to the average discount of the particular CEF being considered. Because absolute discounts and absolute premiums tend to persist, relative discounts and relative premiums matter. Academic studies have shown that current discounts/premiums converge to their average discounts/premiums much more regularly than they converge to their NAVs. Measuring Relative Discounts/Premiums To measure relative discounts, we use a z-score: z = (current discount – average discount) / standard deviation of the discount A negative z-score indicates that the current discount is lower than its average. A positive z-score indicates that the current premium is higher than average. In our opinion, a z-score of less than -2 signals that a fund is relatively inexpensive, and a z-score greater than +2 signals that a fund is relatively expensive. Example 1 Current discount = -8% Average 1-year discount = -15% 1-year standard deviation of discount/premium = 2 z-score = (-8 – -15) ÷2 = (-8 + 15) ÷ 2 = 7 ÷2 = 3.5 With a z-score of 3.5, this fund would be considered relatively expensive. But this doesn’t necessarily mean that the CEF is overvalued. Example 2 Current discount = -15% Average 1-year discount = -10% 1-year standard deviation of discount/premium = 2 z-score = (-15 – -10) ÷2 = (-15 + 10) ÷ 2 = -5 ÷2 = -2.5 With a z-score of –2.5, this fund would be considered relatively inexpensive. But this doesn’t necessarily mean that the CEF is undervalued. Why Are Relative Discounts Helpful? For one, they can help you avoid value traps. Let’s look at the mythical CEF trading at a 15% discount. According to the oft-cited “CEF wisdom,” this would be a good trade because the market is offering investors $1.00 of assets at the bargain price of $0.85. (Forget the fact that the $1.00 worth of assets may fall in value to $0.85!) Consider this: 3-year average absolute discount = -25%. Current absolute discount = -15% Standard deviation over the certain time period = 2 z-score = (-15 – -25) ÷ 2 = (-15 + 25) ÷ 2 = 10 ÷ 2 = +5. A z-score of +5 indicates that, far from being relatively inexpensive–as CEF wisdom would have it–this CEF is relatively expensive. It could represent a classic value trap. Z-score can also help investors uncover potentially truly undervalued and overvalued CEFs. If the z-score is greater than +2 or less than -2, more research would be warranted. Using relative discounts/premiums is a bit of an art. The time period analyzed is a large factor in the z-score. The same CEF may look relatively expensive on a 6-week basis and relatively cheap on a 3-year basis. Even though the CEF may look relatively expensive or relatively cheap, it may not be truly overvalued or undervalued. Consider a CEF that is going to liquidate in one month. Liquidation is a method of making a CEF’s share price converge with its NAV. All assets are sold and the remaining capital is distributed to shareholders. At the point of liquidation, the discount will be 0. Current discount = -2% (in anticipation of the pending liquidation) 1-year average discount = -12% 1-year standard deviation = 1.5 z-score = (-2 – -12) ÷ 1.5 = (-2 + 12) ÷ 1.5 = 10 ÷ 1.5 = +6.7 This CEF is relatively expensive, but with very good reason: A corporate action has narrowed the discount. If an investor attempted a short sale of this CEF in the market, the likely outcome would be a capital loss. There could be a fundamental reason behind a high or low z-score. Do not buy or sell a CEF simply because of its z-score. Further analysis as to why the current discount has deviated so far from its historic average is warranted. Key Takeaways Buy-and-hold investors can use z-scores to determine whether the absolute discount/premium is truly signaling that the CEF is under- or overvalued or whether the absolute discount/premium could be a value trap. Trading-oriented investors can z-scores to find candidates for buying or selling short. (In practice, this is the most common use of relative discounts/premiums.) Regardless of how they are used, they are no guarantee of future investment gains. All that matters once a CEF is purchased is the subsequent total return. Just as absolute discounts/premiums can converge to NAV with no gain for the shareholder, so too can relative discounts/premiums. It is important to understand why a CEF is trading at a current discount/premium that is widely divergent from its historic average. There could be a very good reason, aside from market sentiment.
CEF Distributions Except for a handful of exceptions, CEFs themselves do not pay taxes. Instead, like open-end mutual funds and ETFs, CEFs pass the tax consequences of their investments onto their shareholders. To maintain tax-free status, a CEF must pass onto shareholders, generally speaking, roughly: 90% or more of net investment income from dividends and interest payments 98% or more of net realized capital gains Investors should be aware of the source of their distributions. CEF distributions have four potential sources: 1. Interest payments on fixed-income portfolio holdings 2. Dividends from equity holdings 3. Realized capital gains 4. Return of capital: Pass-through (from master limited partnership investments, primarily) Constructive (from unrealized capital gains) Destructive (investors are literally receiving their own capital, minus expenses) For accounting and tax purposes, distributions must be linked back to the initial source: usually dividends, income, and/or realized capital gains. These are actual cash inflows into the fund. When the distribution exceeds the cash generated from these sources, the fund must ascribe the initial source as a return of capital. Throughout the calendar year, funds estimate the breakdown of their distributions. Shareholders receive a Form 1099-DIV in January with the actual distribution breakdown for the prior year for tax purposes. Any previous information regarding the categorization of distributions are only estimates. Prospective investors are at a disadvantage because they do not have access to the tax forms. They must wait until the fund files its annual statement to see the finalized distribution breakdowns in order to discern its use (if any) of return of capital. Morningstar.com displays a fund’s most recent distributions, along with their sources, as well as distributions for the four previous calendar years. I chose ETV as an example screen shot from Morningstar as it shows all the types of distributions being used. Return on Capital is a red flag for me as it can be very destructive to the fund if you do not know which type of ROC is being used (Pass thru, Constructive or Destructive) I tend to make a worse case assumption when I see ROC is being used. In this case I looked at the NAV history over 2 years and it appears ETV is not using the destructive exclusively but I think in some months it is being used. The NAV in January 2014 was $14.53 and in July 2014 the NAV exceeded $15. But in January 2016 NAV was $13.39. I would not be interested in this CEF for a couple of reasons. One is I don’t trust the ROC distributions and the other reason is that it is selling for $14.84 with a NAV of $14.02. This is a 5% premium which in effect has you paying $1.05 for $1.00 of asset. The takeaway from this is that when looking at CEF’s it is important to look at the distribution and understand how it is being paid. It is one of the several things that need to be evaluated in a different light then regular stocks are looked at.
Putting CEF Research to Work June 9, 2016 jerrymills CEF's, Income, Investment Plans, Watch List Candidates After reviewing the articles I’ve posted over the past few days on what makes up a good CEF and things to watch for, it’s time to put it to work. A good free resource for closed end funds is at http://cefconnect.com which has a very good fund screener along with extensive research information on each fund. So first I have to start with a screen. For this particular screen I’m going to focus on equity CEF’s and not bonds. My personal reasons for this is that I am most familiar with stocks and my knowledge of the bond market is not great so I choose not to learn about them at this time. Screen info: I selected equity type funds and also included specific sector focus to help add to diversification. Above is the criteria I am screening for. I want to limit the exposure of leverage to those funds with 30% or less leverage. My distribution rate is set to range from 5% to 9%. I don’t want less then 5% to get the most return for the amount invested to be worth the risk. But, over 9% is chasing yield and most anything that pays out 10% or higher is doing so because something is wrong and typically they can not sustain such high payouts. They are not worth the risk. I selected monthly on my Distribution Frequency as a matter of personal taste. I already have several stocks in my dividend portion that pay quarterly and I’d like to have some monthly income flowing in. I selected under 0 for Discount / Premium as I do not want to pay more than 1.00 per 1.00 of assets. I was not able to get the Z-Score into the screen shot but I did select a 1 year Z-Score of all under 0 to confirm that fundamentally the relative discount is a value at the current levels. At the bottom of the screener a tally of the number of stocks is kept and changes on each selection you make. This one got down to 9 funds based on my criteria. Clicking on “View Funds” button will bring up the results. So above is the 9 funds that pass the criteria I set in the screen. Am I don yet? No, not even close. Next I will research each of the 9 funds. I will look at several years of NAV discount/premium history and confirm that NAV is at least the same or not significantly lower than around 5 years ago. I’ll also look at 5 years of distribution history for consistency in payments and most importantly how the distributions are being paid, watching out for use of return on capital. Then I’ll look at the charts to see how the technicals look for entry. Once I narrow that down to the 2 or 3 positions I am thinking of taking on, I’ll have to position size based on my earlier post about that topic and then take the plunge. One point I want to make here is that this list of 9 funds are not a buy list and no one should act on these without doing their own due diligence.
