Balancing CEF Data vs. Portfolio Data when Selecting a Closed-End Fund
We are often asked how we decide to purchase shares in a CEF and at what price point we are comfortable buying into a fund or where we would exit a portfolio position. This reminds us that we find many CEF investors only focus their effort on either the CEF-based data or the fund’s fundamental data when deciding to buy a CEF. A closed-end fund is at its basic sense equity exposure to an active manager’s results. We think you should like the pricing and the investment to own the shares no matter who is the portfolio manager.
We would suggest investors first decide that they want to be in the sector that the fund is in and become comfortable that the manager has the experience to do the job well for investors. We find that the most successful CEF investors balance these two areas well over time and through various market cycles. As they are a large part of the CEF universe, we will use Municipal Bond CEFs as the example when helping to explain these concepts in this article. The process can be applied to equity, taxable bond or BDCs funds in a similar fashion.
Fundamental Fund Data:
This is the data that is part of the fund’s disclosures on a typically quarterly basis. It includes allocations for sectors and countries as well as the type of securities; for example, a fund could own both bonds and common stocks in varying percentages. We would also include the fund’s net asset value (NAV) performance on a total return basis. It is important to be able to judge a manager vs. his/her peers and an index over time, as well as how volatile the returns have been historically.
For Municipal Bond CEFs this would allow us to review the state exposure by fund, the mix of credit quality as well as how many bonds were rated vs. unrated. The blended duration and maturity data would help in understanding how the portfolio should act when rates move up or down. We also break out the call risk for these funds into one year forward looking periods to have an idea how much of the portfolio could be required to be reinvested due to bonds that are likely to be called in the near future. The overall goal is to understand what you are buying exposure to when you own the fund’s common stock and whether it meets your investment allocation objectives.
CEF Based Data:
This is the data that people who are comfortable with CEFs often look at first to get an idea on where a fund’s market price is likely to go vs. the movement of NAV. The analysis typically answers “What is the discount and where is it likely to go in the near-to-medium term?” We break these data points into three main groups: 1. Historical and Comparable Discounts, 2. Dividend Sustainability Data like Earnings Coverage, UNII or a fund’s leveraged-adjusted NAV Yield, 3. Shareholder Base / Trading Pressures. This group of data is designed to help us understand who may be a current buyer or sellers of a fund’s shares? Here we focus on short interest, trade volumes and the trends in both activist and institutional ownership of a CEF. One final data point we have found useful over time includes the market price correlation to NAV over the previous 90-day period. We even look at the data vs a peer-group average to try and look for fund level data shifts vs. sector level changes over time.
When researching Municipal Bond CEFs we like to focus on the fund’s earnings yield and the alternative minimum tax (AMT) adjusted yield in addition to the more common market price (or indicated) yield. This helps our firm select a fund where the manager is comfortable meeting the board of director’s distribution level and allows us to select funds for investors that have AMT issues on an equivalent basis. Another point we find investors can often overlook when reviewing earnings coverage or the level and trend of a fund’s undistributed net investment income (UNII) is the data that this figure was last updated. We typically only use this data in our decision process when the data is less than 3 reporting periods old. For example, in mid to late September, we would only consider data reported from June onward.
When buying a closed-end fund, investors typically have the same goal as with any other investment decision; “where can we find an attractive investments where the downside risks are far exceeded by the expected upside potential?” There are two areas that need to be kept in mind when considering a fund for your portfolio. First, where do you expect the NAV to go over time? A fund’s NAV is the anchor point for all future market priced to allow for the typical discounts or premiums to NAV to be calculated. While unlikely to occur, market prices can trend down over a long period of time while NAV rises and conversely, NAV can go up steadily and the market price can drift lower when a fund’s trading disconnects from the value of its investment holdings. Second you need to have an idea on where the current discount or premium to NAV is compared to peer-fund and the fund’s historical levels. You also need to apply some critical thinking to why a fund was at a recent premium or discounts vs. the current price and if the environment has changed materially.
In early May 2013, Municipal Bond Funds were trading at 3%+ premiums on average, but by December 2013 they averaged -10% discounts. Currently they are just beyond -7% discounts to NAV level. Historically the group trades in a normal ranged of -3% to -5% (about a 20 year average) to NAV. In one way, that makes the -7% the peak to valley average for the group. However we would argue, in our firm’s opinion, the factors that lead to the premiums due to exuberance with tax-free income as well as the tax-loss selling carnage of December 2013 are both unlikely to reappear in the next few years. We think -4-5% discounts are the appropriate anchor point and current levels of -7%+ discounts are attractive for investors in need of tax-free income.
Conclusion: The key for CEF analysis to be very successful is to get in or out of a fund when you find the right level of divergent behavior between the portfolio’s data (NAV) and the funds’ CEF data (market price). Because most CEFs trade at levels challenging for large funds or investors ($1B+ in assets) to navigate, there is a real opportunity for individual investors or financial advisors to tap into these inefficiencies in a repeatable fashion. We know it is important to know “what you own” and “why you own it”, but for cross over investors that only focus on fundamental data in the closed-end fund universe, we think you can end up in a few pitfalls. In our experience, a fund being “cheap” and “an activist target” is only helpful if you should own the investment in the first place. You have to experience NAV performance while you wait for the alpha of narrowing discounts.
Disclosure: The views and opinions herein are as of the date of publication and are subject to change at any time based upon market movements or other conditions. None of the information contained herein should be constructed as an offer to buy or sell securities or as recommendations. Performance results shown should, under no circumstances, be construed as an indication of future performance. Data, while obtained from sources we believe to be reliable, cannot be guaranteed. Data, unless otherwise stated comes from the August 29, 2014 issue of our CEF Universe service.