Sunday, February 28, 2010 21 comments

Newbie Thoughts: Closed-end funds are a good playground for amateur investors

If you only look at the mainstream, easily accessible, investment vehicles out there, closed-end funds tend to be one of the most mispriced assets out there. This means two things. If you are a skilled investor, it is an area where there may be great opportunity to earn high returns. Conversely, if you are a newbie, it's probably one area where you can get burned badly.

For those not familiar, a closed-end fund (CEF) is a fund that has a fixed numbers of shares; whereas an open-end fund (such as a mutual fund or an ETF) creates and destroys (redeems) shares over time. CEFs are generally listed on an exchange and traded daily whereas mutual fund shares are not listed on any exchange (but ETF shares are listed.) Shares of open-end funds tend to track the underlying assets closely but CEF shares may not. There is no natural way to arbitrage price discrepancies in CEF shares (other than through influence of fund managers.)

Two Investment Strategies

In my opinion—I'm not an expert and don't blindly follow anything I say—the ideal fund structure is the ETF (exchange-traded fund.) ETFs have an inherent arbitrage mechanism that keeps the share prices close to the underlying asset price, and, from what I understand, ETFs are also more tax-efficient than mutual funds or CEFs (but it depends on some details.) So ETFs are the way to go. Is there a time when CEFs are better? I think there are two scenarios where CEFs are more attractive. Before I say anything, I should note that CEFs tend to have higher MER (management expense ratio), tend to own illiquid assets, may be illiquid, and tend to be more complicated.

One reason you may favour a CEF is because they tend to be actively managed (most ETFs follow some passive index,) are listed on an exchange (mutual funds are not,) and own unusual assets (such as obscure corporate bonds, asset-backed securities, foreign stocks, illiquid preferred shares and so on.) For instance, one of the most popular CEFs is the India Fund (ticker: IFN), which owns a bunch of Indian stocks. India always had capital controls so it used to be difficult for anyone to buy Indian-listed shares but this CEF would give someone access to locally-listed shares. So the first strategy with CEFs is to buy them because they own assets you couldn't find elsewhere.

The other reason for buying CEFs is to take advantage of a mispricing. CEFs often trade way above or below the assets they own. Sticking with the IFN example, the following chart from ETF Connect shows the premium and discount to NAV:


As you can see from the chart above, the premiums and discounts have been very large at times (as a side note, this chart also shows how contrarian the asset was (basically India was totally out of favour in 2000—a good time to buy for contrarians—and on everyone's radar in 2006—probably a good time to avoid.) Buying $1 worth of assets for $0.60 (2000) is always worth considering so this is the other strategy with CEFs. Mutual funds and ETFs will rarely ever trade at such discounts or premiums.

Some Pitfalls

I started writing this post in order to highlight some of Jason Zweig's thoughts in his WSJ column a little over a week ago. Instead, the post ended up being my view of CEFs. Let me go back to the original idea and highlight some items from Jason Zweig.

Zweig's article talks about some dangers with high-yield securities and he zeroes in on CEFs, which often have high yields.


As of last week, 11 of the roughly 650 closed-ends tracked by Lipper Inc. traded for at least 20% more than their portfolios are worth. In many cases, investors are paying those big premiums in pursuit of high yields.

Buy such a fund, and you may double-dose on risk. A yield that looks stable can crumble; then the premium may collapse as panicked investors dump the fund. That leaves you with less income than you expected—and a big market loss to boot.

Look at Dow 30 Enhanced Premium & Income, which paid out 16.7 cents per share monthly in 2009. At year end, the fund dropped its dividend to 8.5 cents, without explanation. The shares collapsed from nearly a 30% premium to a 3% discount. Investors are left with their income halved on a share price cut by one-third.


So the first thing is to avoid is chasing yield. This goes for any instrument—a bond, a stock, preferred share, whatever.

Another thing to watch out for is return of capital:


Many of these funds engage in "return of capital," an odd but legal tactic that pays your own money back to you. There is nothing inherently wrong with return of capital, so long as the fund's investments are rising in value. If not, the capital returned will eat away the fund's asset base.

###

Gabelli Utility Trust, recently at a 60% premium, has paid out at least six cents per share every month since late 2001. Back in 2007, two-thirds came from dividends and capital gains on the fund's investments. Over the past year, however, 90% of the yield has been return of capital.


Return of capital is something that newbies generally don't understand. In some cases, the yield you earn is not "real yield" but is simply the fund or company returning your own capital. You are not really earning anything in that case even though it is a yield you receive. This may or may not be good for you, depending on tax implications, whether you bought the shares at a discount, and various other factors (generally, I would say it is not what you want your company (or the companies held by a fund) to be doing.)

I remember a few years ago when many newbie Canadian investors were tripping over themselves to invest in income trusts—in America, the equivalent would be called royaly trust/MEP/etc—paying out yields of 10% to 15%. What many never realized what a sizeable chunk of the dividends they received were return of capital. Instead of the company paying out a true yield of around 12%, it was only paying, say, 8% yield and 4% return of capital.
So, if you are investing in CEFs, don't blindly take the yield at face value. Also avoid buying CEFs at a premium unless you have a good reason for doing it.

How Come I Don't Own Any?

In regards to the first strategy mentioned above, I have actually looked seriously at several closed-end funds in the past. Like I said, they allow you to get exposure to assets that you otherwise would not have. Good thing I never invested in it but long-term readers may recall me looking at several CEFs that owned various distressed assets. The ones I mentioned in a prior post (in late 2007) would have been a terrible investment (100% loss) since they owned CDOs and mortgage bonds, but it sort of gives you an idea of how CEFs can play a role in your investment if you do make the right decisions. For instance, it would be almost impossible for small investors to invest directly in CDOs or mortage bonds but CEFs would have given you exposure to them. Similarly, one of the other CEFs I sort of mentioned (never really looked at it in detail) was the Morgan Stanley Emerging Market Domestic Debt fund (ticker: EDD), which owns EM debt such as those of Brazil, Mexico, Hungary and the like. It would be difficult for small investors to get direct exposure to such bonds (ETFs are catching up so one should check those first.)

I just never pulled the trigger on any CEF (in regards to the first strategy) but I can see myself doing it if the 2nd strategy was also satisfied.

As for the 2nd strategy (of trying to capitalize on perceived mispricing,) I looked at various closed-end funds in the past but have never invested in a closed-end fund. The main reason is due to my lack of confidence that mispricing will resolve itself in a given amount of time. Most of the time the market does fix the mispricing but I have no confidence in the timing of it. However, I have seen other amateur investors successfully profit off CEF mispricing.

To give an example of the latter strategy, go back to the EM domestic debt CEF (EDD) mentioned above. If you look at its details, you'll find that it is trading at around 15% discount to NAV. Even if you found an ETF with similar holdings, you generally won't find them trading at such a discount (do note that ETFs tend to be more tax-efficient and have much lower MER.) The problem, and the reason I haven't invested in them before, is that there is no guarantee that the 15% discount will close any time soon. If the discount does dissapear, you made an additional 15% but if it doesn't, or if the discount widens, the CEF wouldn't have been better.

Final Word

Overall, I think CEFs are quite attractive as long as you like the underlying holdings, and you can buy it at a discount. If you like making macro-oriented bets, they may be a good instrument for you. Many CEFs also appear mispriced on a regular basis so amateur investors may want to scour the CEF land to see if there are any profitable opportunities.

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21 Response to Newbie Thoughts: Closed-end funds are a good playground for amateur investors

John Y
February 28, 2010 at 9:41 PM

<span>Great topic! ETFs are interesting investment vehicles. I've been following an ETF which owns China H shares for quite some time. (This is an open-ended fund.) It has been trading at >20% below its NTA for many months. (That hasn't taken fees into account though.) To me, the Market is double counting their pessimism towards China's economy. That 20%+ difference is as pure as what Margin of Safety can be.
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P. W. Dunn
March 1, 2010 at 12:36 AM

I think it is important to distinguish between NAV and the aggregate book value of such funds.  The NAV would indicate the market capitalization of all of the underlying securities (please correct me if I'm wrong); the book value would be the shareholders' equity in aggregate of the individual securities in the fund.  The NAV could therefore be well above fair market value.  So Zweig says:  "Investors like Benjamin Graham and Warren Buffett got rich buying a dollar's worth of assets for 60 cents. But when you pay a 60% premium for a closed-end, each dollar of capital returned to you as "yield" effectively has cost you $1.60."  Graham refers (in the Intelligent Investor) to purchasing common stocks at a discount to book value, not fund at a discount to NAV.  It think it is important to be careful about that.

I hope I'm expressing myself clearly enough.  Lets say that a closed ended fund owned 1 million shares of CAT and the book value of CAT was $25, but the market price was $50.  As far as I know, the NAV of a fund would be based upon the price of $50 not the book of $25.  Now imagine that the fund is selling for $45 per share.  You are getting NAV of $50 for $45, but you are still paying $20 above shareholder's equity.  So it can still be too expensive, even though it is below NAV.  What do you think?

MrParkerBohn
March 1, 2010 at 8:50 AM

To John Y:  what fund is this?  I've been considering re-investing in China.

To PW Dunn:  to my understanding, you are correct, the NAV simply refers to the market value of the assets owned by the CEF, and not the book value.  Of course, most good businesses are worth far more than book value.  But it is certainly the case that the market mis-prices many assets at various times, so while a discount to NAV is nice, it is no substitute for due diligence.

MrParkerBohn
March 1, 2010 at 9:22 AM

I like to think about discounts to NAV in terms of the annual boost they give the returns.

For instance, if I expect an asset to generate a 10% annual return, and I can get this asset through a CEF for 90% of NAV, then I can expect to get an 11% return on my investment.

However, if the fund managers charge me 1% a year in fees, then the advantage given by the discount is wiped out.

P. W. Dunn
March 1, 2010 at 12:00 PM

Thanks Parker.  You are right.  Some companies with high book value aren't worth the trouble (e.g., Nortel) because they had insufficient revenue.  Book value became an important factor in the latest downturn in the market.  Many companies, including Canadian banks, were selling at below book, which meant that courageous investors could buy the future earnings of these companies for essentially nothing at all (so Graham).

Sivaram
March 1, 2010 at 6:43 PM

Good discussion by all of you here.


John Y, if you don't mind disclosing, what is that Chinese fund?


PW Dunn, yes, you are correct in saying that the NAV of CEFs refer to the market values of the underlying asset and not the book value. Although it's not as great as buying something below book value, I do think that buying below NAV can be valuable. If you believed that the NAV represented the value of an asset (i.e. it wasn't overvalued) then the lower price you get through a discounted CEF can be very profitable.

Classic value investors, such as Benjamin Graham, paid a lot of attention to book value but I would argue that investors such as Warren Buffett, who rely more on earnings power and "moat," don't worry too much about book value. Good companies with a moat rarely trade anywhere near book value (except during severe distress) so you will never buy those companeis if you are waiting for them decline below book value. The "modern" Buffett (say 1970's+) has generally bought companies irrespective of book value. The latest major investment, Burlington Northern Santa Fe, which was nowhere near book value, is a good example of that.

Sivaram
March 1, 2010 at 6:56 PM

MrParkerBohN: "<span>I like to think about discounts to NAV in terms of the annual boost they give the returns. 
 
For instance, if I expect an asset to generate a 10% annual return, and I can get this asset through a CEF for 90% of NAV, then I can expect to get an 11% return on my investment. 
 
However, if the fund managers charge me 1% a year in fees, then the advantage given by the discount is wiped out."
</span>
<span></span>
<span></span>
<span></span>
<span>Yep... very good point.</span>
<span></span>
<span>I think your thought process is the right one. One of the most insightful things I ever learned was to think of stocks (or any other asset) like a bond (I started thinking this way after reading Warren Buffett's "<span>How Inflation Swindles the Equity Investor</span>"--this is one of the most influential investment articles I ever read.) I think your thinking is sort of similar to a "bond approach." </span>
<span></span>
<span>When you buy assets at a discount, you basically increase your annual yield. And as you point out, you also need to factor in costs, such as MER into it. </span>
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<span>I generally do not look at assets if they didn't have a 20%+ discount. Maybe that's being "too greedy" and I'm making a mistake; I don't know. All I know is that a 10% discount can be eaten up by all sorts of fees, bid-ask spreads, taxes, etc.</span>

P. W. Dunn
March 1, 2010 at 8:13 PM

Don't downplay Warren Buffet's view of book value too much, because he does pay a lot of attention to it.  Here is how he starts his letter to shareholder this year:

"Our gain in net worth during 2009 was $21.8 billion, which increased the per-share book value of both our Class A and Class B stock by 19.8%. Over the last 45 years (that is, since present management took over) book value has grown from $19 to $84,487, a rate of 20.3% compounded annually."

Cheers.

P. W. Dunn
March 1, 2010 at 8:16 PM

Siv:  here's an html version (easier on the eyes) of the article you reference, http://www.valueinvesting.de/en/inflation-equity-investor-by-warren-buffett.htm

Sivaram
March 1, 2010 at 8:24 PM

LOL... the one you linked to is the one I read initially a few years ago. I just took a look at the one I linked to...and... man... that's horrible and almost illegible :-[ ... sorry about linking to something almost impossible to read... I believe there were a few spelling mistakes and typos in the one you mentioned (the one I read intiially) and that's probably why I never linked to it before.

Sivaram
March 1, 2010 at 8:27 PM

Here is another one I Googled and found... not sure if it has typos but I'm going to link to this on my reference page from now on...

http://www.rbcpa.com/WEB_Fortune_May_1977_How_inflation_swindles_the_equity_investor.html

Sivaram
March 1, 2010 at 8:35 PM

Buffett still looks at book value but I suspect he doesn't rely on it much.

As for his annual letter, I think it's proper to put heavy emphasis on book value because, from what I understand, (i) book value is a good measure of the worth of insurance companies, and (ii) it's often more accurate to look at book value for holding companies (Berkshire Hathaway is a holding company.)

Even with that said, Buffett has continuously repeated that the book value is not representative of the true value of Berkshire Hathaway. He has generally claimed that book value understates the value of Berkshire Hathaway.

P. W. Dunn
March 1, 2010 at 9:12 PM

In consideration of book value, have you ever thought of investing in Canadian junior oil companies?  Some are still currently selling below book (e.g., CTA, MOX).  I invested in a lot of shares of MEL when it was still TFL because it fell in January 2009, I was buying them as low as .39 cents (TD Waterhouse was reporting its book per share at $3.40--it is currently at 3.25, but its shares have been considerably diluted over the Summer and Fall of 2009).  For me it may have been the deal of a lifetime.

Sivaram
March 1, 2010 at 9:31 PM

The only time I invested in juniors was about 5 years ago when I was bullish on the commodity complex (I'm bearish now so I haven't looked at them seriously of late--also, many high quality companies were sold off last year so, you could have found great bargains with mid and large companies as well.) The investments back then were more of a macro bet on commodities rather than anything to do with fundamentals (such as book value.)

I think you have to do a lot of homework to figure out what the true book value for those companies. There are several issues you probably should watch out for:

(i) The more junior the company is, the more capital it may require to develop its fields. Even if the balance sheet says that the company has $100 million in book value, the company may require $500 million to develop a gas/oil field. You are looking at massive capital raising (often through heavy share dilution)... If it's more mature, has producing fields, and reasonable free cash flow, then book value may be worth a bit more.

(ii) The book value of resource companies are probably overstated by a huge margin if the company is not a going concern. That is, if the company decides to liquidate itself or sell off its assets, I am doubtful the company can realize the book value. The thinking behind book value is that it is assets in excess of liabilities (that's the defintion) and shareholders have that cushion. But if the assets are not worth much during liquidation or sale of assets, book value may not mean much.

(iii) Oil/gas reserves and other resources have economic value that depends on the commodity price. You have to be really careful that your junior's book value isn't because of high commodity prices. The regulators are strict when it comes to including assets on the balance sheet but if oil prices decline, what you perceived as asset may not be. I can't remember how the reserves go on the balance sheet or if they don't at all. You have to understand what the book value represents. In contrast, the book value of, say, an industrial or technology company is straightforward. The book value assets rarely fluctuate much (the key things that impact it are depreciation and inflation which are more predictable.)

Sivaram
March 1, 2010 at 9:33 PM

As for the spectacular returns on those companies last year, the returns probably came more from the commodity price appreciation rather than anything to do with the company or quality of its assets. If oil stayed at US$30 or if it drops back to that tomorrow, I suspect many of those companies would be back where they were--even if the book value remained the same.

P. W. Dunn
March 2, 2010 at 9:09 AM

Thanks Sivraram for sharing your valuable point of view.  I find it helpful.  You often call yourself a newbie, but you have a lot of knowledge.

I don't know exactly what book value means either.  I assume it is not NAV, since that is reported as a separate item by mining and oil and gas companies.  Here is what I think:  Book value would be the value of assets minus liabilities, while NAV stands for unrealized but proven and probable assets.  Thus, lands acquired by junior oil, money in the bank, and other property and equipment would be book value, while oil and gas reserves would be NAV.

My thought on the recent opportunity in the junior oil gas:  it is partially related to the rebound in commodities, but I think that oil is stabalizing at 60-85, while gas is definitely low and may remain low for a long time.  I am guessing that what happened is that investors had to abandon their holdings because of too much leverage and fear has also kicked in, and this provided an opportunity to buy at unusually low prices.  At that point they became extremely interesting investments for risk tolerant investors, well below book, and their book was largely represented by their land leases.  As a result of not being able to get further credit, many of juniors looked to mergers (mel) or the sale of land (cta), in order to create capital for drilling.  It remains a risky investment if the NAV is low and book is high because you aren't certain what success they will have drilling.

I remain bullish and long on the junior sector and have thus missed opportunities to sell at huge profits when they have occasionally spiked higher only to recede a few minutes later.  Here are some of my reasons (1) fear of inflation--resources are a potential hedge against inflation; (2) foreign investors, esp. the Chinese and Koreans, are bringing billions of new money into the Canadian oil and gas sector; (3) many of the juniors (and others, e.g. nae.un, pmt.un, erf.un, cpg, bnp.un) are exploiting the light oil resource of the cardium pembina which is a known oil field using horizontal drilling with multifracing which gives them a very high ROR for their drilling capital.  (4) the US fed is making it more difficult to drill, and some estimate that the US will lose over a trillion dollars in revenue as a result--Canada will most hopefully pick up much of that revenue.  (5) The demand for land leases has recently rebounded and so the junior oils should be able to maintain their high book value.

Anyway, sorry this is off topic, but I will probably use this conversation to create a blog post myself.  Thanks again.

craigatk
March 5, 2010 at 4:49 AM

Great discussion, your blog has really taken off since I started reading years ago. First visit back to the site, usually just read in my RSS reader. My own experience saw me taking advantage of 2008 sell off in "risky" assets worldwide on several names, including one close ended investment fund listed in LSE that is a feeder fund for Brevan Howard's hedge funds. There are several traded for the BH Global (includes equity exposure) and BH Macro (which is Brevan Howard's premier rates/fx/credit/commod Macro fund) across GBP, USD and EUR. Weekly NAV are posted online, and there was a tremendous discount at the time 20-25% from cash value NAV. However, Brevan Howard is probably the top macro hedge fund in the entire world and have a TREMENDOUS track record! They continued making money and their track record is publicly posted as disclosure for this publicly traded CEF! The spread has now closed and the CEF trades at NAV or slight premium, but I continue to hold, as Allan Howard and his team are exceptional traders and continue to make money. I will be tempted to sell if it trades at a big premium to NAV, say 10+% but for now, happy to have the chance to see 15-20% return per year, and know that I bought in at a significant discount. Keep up the good work Sivaram, always enjoy reading your stuff!

craigatk
March 5, 2010 at 4:51 AM

Best thing is, I didn't even come up with the original trade idea. Saw a cool FT article on "what am I buying today" where they interviewed somebody around Oct 2008, and he said he was backing up the truck on BH Macro. That set the ball rolling for me. ;)

Sivaram
March 7, 2010 at 10:35 PM

Congratulations on that investment... and thanks for the kind words about this blog :)

I'm not familiar with the British funds and am not familiar with Brevan Howard but it sounds like you picked the right manager.

BTW, are you familiar with any exchange-traded funds (CEFs) or just individual stocks listed on LSE that are a good proxy for the Irish or Icelandic economies? I am wondering if those battered economies are worth investigating.

craigatk
March 8, 2010 at 1:57 AM

Wow you sure enjoy the contrarian angle! I unfortunately know next to nothing else about the LSE and any Irish/Icelandic ideas.

If you recall, we had some e-mails a few years ago about Japan and the cheap valuations, as we share that interest. I am still living in Tokyo area ... but continue to be underwhelmed with Japanese equities, mainly because of unfriendly management and their view that shareholders are the least important constituent in a company's circle of interest...

Found much more ideas overseas in English language areas where management cares about shareholders and their return on equity. Any views on how cheap Japan currently is and any view on how to make money at it?? 

Sivaram Velauthapillai
March 8, 2010 at 9:38 AM

Heh... yeah, that's kind of extreme contrarianism... it could blow up easily so one has to be careful with those areas...


As for Japan, I share your sentiment on Japan. Namely, valuations look cheap but, as long as shareholders have little influence over their companies, it's hard to be very optimistic. Greenbackd, the excellent special-situation-oriented value investing blog, recently touched on Japan. He/she seems more bullish on Japan but I'm still unsure:

http://greenbackd.com/2010/02/11/activist-investing-in-japan/
http://greenbackd.com/2010/02/12/the-kabuki-narrative/

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