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Avoid This Rookie Error in Fund Investing

Investing in high-premium CEFs makes no sense, especially since alternatives abound.

Mike Taggart, CFA, 07/30/2012

In last week's article, Cara Esser pointed out the poor year-to-date share price total return performance of, among others, Sprott Physical Silver Trust PSLV. As of July 26, the fund is sporting a one-year net asset value total return of negative 31.6% and a one-year share price total return of negative 41.6%. This share price performance is simply the latest case study of why investors should never--and in my opinion this is an emphatic never--buy a closed-end fund trading at a double-digit premium to its net asset value.

Recall that this fund launched in October 2010 at $10 per share. It was a fortuitous launch, as silver prices were about to embark on a strong run from the low $20s to the high $40s. Two and a half months later, the fund offered more shares to the public at $13.20, and earlier this month the fund had its second secondary offering, which priced at $11.05 per share. Along the way, some investors frantically bought shares, so much so that the premium rose as high as 33.9% in early January of this year. Last year, on July 26, the premium was 20.02%. This morning, that premium stood at a more reasonable 2.9%.

Anybody following commodity prices realizes that gold and silver have stagnated this year and are below their 2011 peaks. Given its industrial uses, silver is down more than gold in the past 12 months. In fact, since this fund invests in nothing but silver bullion, its net asset value--though slightly affected by the reinvestment price of the recent secondary offering proceeds--is roughly that of silver. Moreover, Eric Sprott, the personality behind this fund, is renowned among precious metals investors for his prescient investments, at least historically. So there's nothing shocking in the fact that the fund's net asset value is down 31.6%, especially since London FIX silver is down 31.06% over the past 12 months and an investible alternative, iShares Silver Trust SLV, is down 31.4%. Investors in commodity funds should expect high volatility from the underlying, undiversified portfolios.

What also isn't too shocking is that the premium has gone out of the fund. At least, anyone familiar with CEFs shouldn't be surprised. Unfortunately, I'm increasingly of the belief that many people and their brokers who dabble in CEFs either don't understand that CEFs can trade at premiums or--worse--don't care about such premiums. I find it difficult to feel bad for such investors, but I do feel duty-bound to warn my readers--yet again--of such avoidable investment malfeasance.

Let's consider investors who bought this fund at a 33% or even a 20% premium. What were they thinking? What was their broker thinking? Yes, it's a decent fund for gaining exposure to silver prices, because the fund owns nothing but silver bullion (and a wee bit of cash). Yes, it's run by someone well-known among commodity investors. But seriously, those folks were willing to pay $1.33 and $1.20 (respectively) for $1.00 worth of silver! People complain about CEF IPO prices, and precious metals investors complain about the retail cost of trading physical gold and silver, but those costs are child's play compared to this.

Consider, too, that alternatives abound for exposure to silver through an exchange-traded product. To name but one, iShares Silver Trust is an ETF, and as such its discount and premium don't get too out of whack with the underlying net asset value. Again, there was no reason to pay up so dramatically to gain access to physical silver exposure. There never is.

CEF share prices are driven by many things. One of them is the demand surrounding the sector assets in which the fund invests. Last year, with silver prices reaching new highs, investors couldn't get enough silver. Not only did this push silver prices up, but with investors racing to get in the doors of Sprott Physical Silver, they pushed the premium to unwarranted heights. As a CEF investor, you not only need to be aware of how your fund's underlying assets are performing, but also of what your fellow and prospective shareholders are doing.

Patience is definitely a virtue when it comes to CEF investing. There are 543 CEFs traded in the United States with at least a five-year history, according to our database. Over the past five years, 433 of these (or 79.7%) have traded at both premiums and discounts. The discounts have narrowed and turned into premiums; the premiums have withered and turned into discounts. More fascinating, only one fund, BlackRock Virginia Municipal Bond BHV, has maintained its premium--that is, never traded at a discount--over the past five years. Just one fund! Let that be a warning to anyone who currently owns a high-premium CEF.

Mike Taggart, CFA, is the director of closed-end fund research at Morningstar.
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