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The Closed-End Fund Analysis Trifecta

August 27, 2012

At CEFA we consider three important details when doing a primary review of a closed-end fund (“CEF”). We track almost 50 data points per week per U.S.- listed CEF with “CEFA’s Closed-End Fund Universe Report” (CEFU). The key areas we suggest investors and investment professionals to monitor are: Entry Point Risk, Dividend Risk and NAV Performance.

Entry Point Risk: The NAV vs. Market Price for a CEF

We find it is important to not only understand the current discount or premium (disc/prm) on an absolute basis (amount + from zero) but also historically compare the disc/prm to itself as well as to it peers. CEFA uses a 90-day relative discount or the current disc/prm vs. the previous 90-day average disc/prm. We also compare funds on the 1-year z-statistic (Z-Stat), which is the current disc/prm vs. the 52-week average disc/prm then divided by the volatility (or standard deviation) of the discount. A third relative measure of a disc/prem would be the discount range, essentially plotting the current disc/prm as a percentage between the 52-week discount high and low. The goal for these data points is to help determine if a fund is currently over or under priced.

Rules of Thumb

• We generally like an absolute discount over an absolute premium but recommend close reviews of Dividend Risk and NAV Performance before simply buying a dividend yield or deep discount.

• Having a negative 90-Day Relative Discount means buying a fund at a lower than average discount. This is often a good place to buy into a fund as long as it has positive fundamentals, but CEFA again suggests you have an understanding of the dividend’s security and the manager’s NAV performance before making any buy/sell decisions.

• A 1-year Z-Stat between -1 and +1 is within one standard deviation of the disc/prm range for the previous year is a relatively normal place for a disc/prm to fall. When the Z-Stat gets over +1.5, the current relationship starts to gain statistical significance. Z-Stat exceeding +2 are rare occurrences. However, a wide Z-Stat does not scream a buy or sell without a review of possible dividend policy changes and NAV performance. For perspective, our CEFU report* shows that out of 614 CEFs, there were only 41 CEFs with a Z-Stat over +2 and four CEFs with a Z-Stat below -2.

• When looking at a fund’s disc/prm, we find it useful to compare it against its peer-average disc/prm as it can be a way to identify a fund with modest downside protections and above-average upside potential. However, no data can guarantee future performance, relative or absolute.

Dividend Risk/Security

The average closed-end fund is currently showing a 6.3% annualized forward-looking distribution yield,* making it clear that the dividend is often a significant component for a CEF’s total return. For the 614 current CEFs, 79% have distribution yields over 5%. There are more than a few CEFs that have dividend levels CEFA considers ridiculous (usually +10%) and unsustainable going forward.

Rules of Thumb

• No single data point can guarantee a dividend increase or decrease. It only can suggest where risk or opportunity might lie. Only a fund’s Board of Directors/Trustees can make dividend changes.

• Even if UNII or earnings are negative or lower than the dividend level, look at how peer funds are doing for the same data points to give a more realistic analysis.

• The current level of a fund’s discount or premium can also help identify how much anticipated risk is built into a fund’s distribution policy or level.

• Do not forget that performance is a combination of “yield” and “capital appreciation or loss”. Both factors need to be combined for any accurate comparisons.

• Another important concept to note with UNII data is that it shows a fund’s life-to-date balance and can be impacted by accounting and IRS adjustments over time. The older a fund, the more important the trend is vs. the absolute level of UNII.

Net Asset Value Performance

A closed-end fund is best described as three things:

1. A near permanent number of shares without daily in/out flows (open-end funds) or the involvement of creation units (exchange-traded funds).
2. Active portfolio management involving portfolio managers and a team of analysts vs. a passive index or a predetermined formula.
3. Investor liquidity or the ability to have the shares trade on a U.S. exchange.

While all CEF shareholders buy and sell at market prices on exchanges, we find it best to track a portfolio manager using NAV performance. This takes their cost into account vs. the investments. Even though there are funds with large differences in how the market price trades vs. the NAV movement, our CEFU  report* through its 90-day NAV/Market Price correlation figures, indicate that over the long-term a CEF’s market price eventually follows its NAV trend.

Rules of Thumb

• We suggest comparing a CEF’s NAV performance to their peer funds and a tracking index. This is a way to confirm the fund is a good investment vs. reacting to a discount or dividend hype market catalyst.

• CEFA doesn’t dwell on expense ratios, as growing capital from its current level is far more important than a reasonable expense. NAV calculations adjust for a fund’s operating and management costs by comparing funds on a net basis.

• We do not completely ignore expense ratios, but it is a secondary factor in our CEF research process.

Conclusion: A closed-end fund is a structure around an investment objective. For more information on CEFs, we suggest you attend any of our live or on-demand webinars (beginner to advanced levels) or visit our web site (www.cefadvisors.com).

 *CEFU Report as of August 10, 2012.

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