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Think Big Premiums Don't Matter? Think Again

History tells us over and over that high premiums are to be avoided.

Mike Taggart, CFA, 11/02/2012

A lot has been made about high-premium closed-end funds in the past month or so. The support for purchasing high-premium funds, apparent in the high premiums themselves as investors voice their opinions via their portfolios and in various articles that have sprung up here and there, is surprising--even shocking--to me. Those of us who closely follow CEFs realize that such investors make for an inefficient CEF market, and perhaps you can make some money off of their ineptitude.

But a large part of what we do here at Morningstar is educate--or at least make a strong attempt to educate--investors about how to put their money to work for them. Hence my amazement at how some people invest.

Back at my second job in the financial industry, I worked in a call center for a mutual fund company. People would call either to buy or sell their shares or to get information about one of our funds. I remember being shocked by most callers' lack of knowledge about investing. I wasn't too savvy then myself, but it dawned on me quite early that most callers--and I spoke with dozens every day for a year--put more time into choosing what to have for dinner than how to invest their money. The memory of those folks is one reason I am so keen to help our readers understand what they're getting into when it comes to CEFs.

When it comes to CEFs having their high premiums dissipate as logic intrudes into the market for the shares, I am most unsettled by people who blame the messenger. If I point out that the emperor has no clothes, am I to be blamed for his nakedness or is he? When an analyst, a reporter, or any other investor with a bully pulpit points out the ludicrousness of paying $1.50 for $1.00 worth of assets when there are plenty of cheaper investment alternatives out there, they are more than likely attempting to warn investors of impending doom. If the premium falls and investors in that CEF see its value decrease, in my opinion there's nobody to blame but themselves. If they bought the fund at a reasonable valuation, they should have sold their shares as the premium ballooned. If the premium was already high, they shouldn't have bought the shares in the first place.

Successful investing entails making more smart decisions than stupid ones over the long term, stacking the risk-reward deck in your favor before buying shares, and reassessing your portfolio a few times a year. One of those reassessments should include whether a CEF in the portfolio is trading at an unsustainable premium.

Patience Pays Off
During the past three years, 73% of CEFs with at least a three-year history have traded at both a discount and a premium. Looking out to five years, that figure climbs to 80%. During the past five years--what we consider to be a full market cycle--419 CEFs have traded at premiums and of those, only one (one fund out of 419!) has managed not to also trade at a discount at some point during the cycle. This fund is BlackRock Virginia Municipal Bond BHV, which has traded between premiums of 50.7% and 8.3% during the past five years. When we look at three years, 415 funds have traded at premiums and only 24 (so far) have not also traded at discounts. If you're buying high-premium funds, you're setting yourself up for an eventual capital loss. It's really that simple.

There are many ways we could present data to further bolster our claim. Smart CEF investors--and there are many on our discussion boards--know to stay away from high-premium funds. Many won't touch a CEF trading at any premium, though we're perhaps a bit more liberal and recommend staying away from double-digit premium funds. It has been proven time and again that being a successful individual CEF investor requires patience and a contrarian attitude, so buy CEFs trading at excessive discounts. Some institutional investors and traders can get away with owning high-premium CEFs because they watch the markets like hawks. Most individual investors don't have the time or the wherewithal to successfully execute such an undertaking.

The bottom line, which we can't stress often enough, is to stay away from high-premium CEFs. If you like a CEF that's currently trading at a high premium, put it on your radar screen and wait until its premium becomes a discount, as it almost inevitably will. It's difficult enough to invest with a portfolio manager who can consistently outperform his or her benchmark on a net asset value basis. By purchasing or owning high-premium CEFs, you're simply stacking the odds against yourself, and with no one else to blame.

There is no data and commentary on individual closed-end funds this week due to technical difficulties.  

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