Saturday, January 21, 2012

How to Buy a Dollar For 90 Cents

Arbitraging Market Inefficiencies In Closed End Funds

In a world of universally low yields and high volatility, it’s a tough time to be an investor.  Many people are nervous and prone to shoot first and ask questions later.  Since “safe” options like treasury notes and CDs are now offering yields less than inflation (a TIPS auction was recently concluded at a negative real yield), there really is no obvious place to hide.  Despite this difficult climate, there are still ways to generate returns that are in excess of current bond yields.  One option is to take advantage of other people’s panicky sales and buy dollars for 90 cents by picking through the market for closed end funds.

You might well ask, “What is a closed end fund (CEF)?”  CEFs are a very old way to buy a pool of investments as a retail investor.  CEFs are structurally similar to a mutual fund (AKA an open end fund): the fund owns a portfolio of assets and investors buy shares in the fund to receive a pro rata share of the gains, losses and income from the underlying assets.  The primary difference between CEFs and mutual funds is that CEFs have a fixed number of outstanding shares, while mutual funds can have as many shares as necessary.  In a mutual fund, new shares are created when an investor deposits new money into the fund and old shares are cancelled as investors redeem shares for cash when they sell.  In contrast, when an investor wishes to buy a piece of the CEF’s portfolio the only way to do so is to buy shares from another investor who wishes to sell, generally via trades on a major stock exchange. No new shares are created or destroyed  when any given investor buys or sells CEF shares.  Since a CEF is a fixed size pool, the shares trade at whatever the market will bear rather than at net asset value (the value of the underlying portfolio; NAV) as is the case with mutual funds.

What does this mean to us as retail investors looking to get a leg up any way we can?  Since the price is set by whoever (possibly a fool or an idiot) made the last trade, CEFs frequently trade for significantly more or less than the value of the underlying assets in the portfolio the fund holds.  Sometimes these premiums and discounts to NAV can be extreme.  For example, at the time of writing the PIMCO Global StocksPLUS fund (ticker PGP) traded at a premium to NAV of 76%.  Put another way, investors are currently paying $1.76 for every dollar (!) of assets in the fund when they buy these shares, and they are paying a 1.9% annual management fee for the privilege.  On the other end of the scale, there are numerous CEFs that trade at a discount to NAV of greater than 20%.  Since these premium and discount levels can and do change over time, patient investors with a reasonable amount of risk tolerance can often take advantage of these fluctuations.

One way to take advantage of these premiums and discounts is to identify CEFs that are trading at unusually wide discounts to NAV, buy them, and wait for the excessive discount to decrease.  I like to do this with funds that own fixed income assets rather than equities or other highly volatile assets.  The reasons I prefer fixed income CEFs include:

Ÿ  Bonds and the like tend to have relatively stable prices so you can probably wait for the discount to decrease and have some confidence that the value of the underlying assets won’t drop so much that you lose all of the narrowed discount (and more) because the stock market hit an air pocket
Ÿ  Fixed income CEFs typically have a far more generous yield than equity CEFs.  Since it can take several months or longer for the discount to NAV to decline, it really helps to be getting a current return while you wait
Ÿ  Unless you get into rather exotic forms of fixed income, most bonds have a fairly liquid market and there is not a lot of risk that the assets will be incorrectly valued by the manager when calculating NAV.  In contrast, I have seen equity CEFs that have a significant portion of their assets in things like private companies (no traded equity on which to base a market value estimate).

The mechanics of picking funds are fairly simple.  I use the free CEFConnect website to search through the world of CEFs and do some basic due diligence.  The site is sponsored by Nuveen, one of the largest managers of CEFs, so be aware that you will be marketed to a bit.  Simply, I go to the site and click the link for the Fund Screener.  I then select all of the municipal and taxable fixed income fund categories and run the search.  The resulting list of CEFs is huge, but we really only care about the ones trading at a fat discount to NAV.  To see them, sort by discount to NAV (click of the word “Discount” at the top of the column of premiums and discounts, click a second time if it sorts by highest premium first).  Voila! We now have a nice list of fixed income CEFs sorted by descending order of discount to NAV.  It looked like this when I ran the screen:

This menu of CEFs now requires further scrutiny.  As is the case with just about every investment type I have ever seen, there are good and bad picks among otherwise similar CEFs.  Criteria I use as a first pass are fund size (over $500MM and the larger the better), leverage (35% or less), and management fee (ideally 1% or less).  I also look at the fund’s past performance to get an idea if the manager is completely inept, although modest recent underperformance isn’t a deal killer for me.  I also review the fund’s history of discount levels (if a fund always traded between a 10 and 15% discount over the last few years, I don’t want to buy it at a 10% discount).  Finally, I typically will not buy a fund with a discount of less than 10% (I want a fat discount out of which to squeeze additional returns).  Some of these characteristics are visible in the list of funds from your search and the rest you can see if you click on the ticker of a fund in the list and look through the summary information for each fund that CEFConnect has conveniently assembled.  Once you find a fund that passes the initial screening, it is a good idea to do additional due diligence, such as reading any recent investor letters, reviewing the most recent annual or semi-annual report, and buzzing by the sponsor’s website to see what they have to say about the fund.

So you have done the digging and found a promising fund.  Before you log into your broker’s website and click the “buy” button, there is one last gut check: do you want to own the underlying assets the fund owns?  For example, the Western/Claymore Inflation-Linked Opportunities Fund (WIW) passes most or all of my listed criteria with flying colors, yet I don’t want to own it.  Why?  I think that TIPS (which make up 90+% of the fund’s assets) are very overvalued and I simply do not want exposure to the asset class.

Assuming I get past the final gut check, I buy and sit on the funds.  Every so often (perhaps once or twice a month) I will check the discount level at which the fund is trading.  Ideally, I buy a fund at a 10+% discount and sell when the discount drops below 5%.  Sometimes this happens pretty quickly (a few months), other times it can take a year or longer.  In the meantime, since I have chosen fixed income CEFs and the managers know that most investors buy these things in part for yield, I generally receive yields of 5% or greater.  The value of the underlying assets flops around a bit, but since these are fixed income funds they don’t move around that much (at least compared to equities).  The returns to this strategy are the yield on the fund plus whatever narrowing of the discount I capture plus (or minus) fluctuations in the value of the underlying assets.  I typically get a 5% or better cash yield and over the course of maybe a year or two capture an additional 5 points of discount narrowing, so before the underlying assets move a penny I am looking at a 7 to 10% yield if things go well (sometimes they do not).  I try to own a few to several funds so that the money I have invested in this strategy is at lessened risk of a particular fund getting into serious trouble.

Why do discounts widen and narrow?  Discounts arise for a number of reasons, but the most common reasons are underperformance by the specific fund, tax loss selling, and the fund happening to be in an asset class or strategy that is out of favor with investors.  Tax loss selling is perhaps one of the more predictable reasons, since November and early December often see discounts widen.  However, some types of funds inevitably see big discounts upon certain events, such as covered call funds when the equity market swoons.  Discounts narrow for a number of reasons as well, such as the cessation of tax loss selling, the fund’s asset class coming back into favor, or the fund becoming the target of an activist investor.  The last factor can result in rapid narrowing of a discount, as an activist can force the manager to liquidate assets and buy back some shares, merge the fund with a more successful one, change the fund’s strategy, or in extreme cases liquidate the fund and distribute assets or cash to the fund’s investors.

Of course, there are a number of risks inherent in attempting to capture excess returns from CEF discounts.  First, the discount might never narrow or might widen out even further.  There is generally no way to know where the discount will go in a given time period, although I try to hedge against this by picking a reasonably liquid fund with a discount that is among the largest for that type of fund.  Second, the underlying assets in the fund might collapse, overwhelming any narrowing in the discount.  Investors who bought discounted CEFs holding non-agency mortgage bonds (including subprime) in 2007 got clobbered regardless of what the discount did.  I try to avoid this risk by sticking to fairly simple funds that I understand and which appear to be relatively modest risk (note: I include things like junk bonds in this category, so my “modest” risk might be your “very high” risk).  Third, many CEFs borrow money to invest (see the max leverage ratio screening rule of thumb I use) and under certain circumstances they may have to liquidate assets at exactly the wrong time to repay some or all of what they have borrowed.  I try to limit this risk by favoring funds with lower (or no) leverage.  Finally, there are the usual risks that go with every fund managed by some person(s) with lots of letters after their names.  I assume that my readers are at least passing familiar with mutual funds and the risks there apply to CEFs.

One last thought for the very laziest readers: Cohen & Steers Closed End Opportunities Fund (ticker FOF) is a CEF that pursues essentially the strategy I have described above (and oddly enough FOF itself generally trades at a discount to NAV).  If you like the idea of this strategy, but are too, um, lazy to do the relatively modest amount of digging it requires, one could simply buy some shares of FOF.  I own a small amount of this fund (this is NOT an endorsement or recommendation) mostly as a reminder to look at FOF’s holdings every so often to make sure there isn’t a juicy prospect trading at a fat discount that I have overlooked.  Just remember that any purchase of FOF would add an additional layer of management fees.

As always, do your own due diligence, consult your advisors, keep out of reach of children, close box before striking match, etc.  BE CAREFUL WITH YOUR CAPITAL.  You can lose money doing this.

Disclosure: I am long FOF.

1 comment:

  1. Enjoyed your articles on Junk Bonds. In fact, I would like to re-publish them on the site LearnBonds or BondMoves. (both dotcom, I want you to know this is not a post trying to get SEO links).

    We are looking for contributions for both sites.

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    Best regards,

    Marc Prosser
    Managing Partner
    Marc Waring Ventures