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2 Huge Mistakes That Great CEF Investors Avoid

Proper comparisons are essential for long-term investment success.

Mike Taggart, CFA, 03/08/2013

If, upon entering a grocery store, you were told that pork is cheap, and you were already inclined to purchase a pound or two of pork, you might head over to the butcher's counter to check out the price. If the butcher then shouted out to you "Yes, it's cheap! Cheaper than the ballpoint pens over in aisle five," well, you would probably assume these were the ravings of a lunatic, chuckle to yourself, and go about your business.

Cheap is a relative term. Cheap compared with what? There has to be another price against which we can make a comparison. Is pork cheap compared with where it was priced last week? Is it cheap compared with other animal protein, such as a pound of beef? Most importantly, if you come at it from an investment standpoint, is it cheap compared with what it will be priced next week--when I actually need it for a family dinner?

It's the last question that, in my experience, trips up investors time and again. For, as surely you can realize, we can't know definitely--and most of us would say even remotely--what the future holds. We don't even know what the price of pork will be next week. So, how can we, as investors, have any certainty what the price of our investments will be worth next week, let alone next year or five years from now?

Closed-end fund, or CEF, investors make comparisons akin to figuring out the price of pork all the time. In CEF investing, there are at least two mistakes investors make all the time. First, they get too caught up in the discount and premium price of a CEF. Second, they fail to look at the proper relative relationship when seeking a CEF. Let's make sure you don't fall into this trap.

To begin with, funds that are structured as closed-end funds are not mutual funds. Sure, you can treat them that way. You can also treat them as stocks of corporations. In truth, they are somewhere in between. If it is an unleveraged CEF, it's going to behave more like a mutual fund; if it is a leveraged CEF, it's going to behave more like a stock. I think of CEF shares as the stocks of micro-capitalized corporations which have, as their sole business, the investment of capital in a portfolio of securities.

Now, a couple of guidelines spring from that starting point. First, as I see them as companies, I want to figure out what their underlying businesses are. So, I divide them into groups. This takes a lot of time and effort, but I guarantee you that successful CEF investors have done this. I think of CEF investment professionals like Thomas Herzfeld and his team, who manage the recently launched Virtus Herzfeld VHFAX or Patrick Galley and Steve O'Neill of RiverNorth who manage--among other funds--RiverNorth Core Opportunity RNCOX. If you read their books, interviews, and articles and talk to them long enough, you'll quickly understand that they don't look at a CEF's discount but at a CEF's relative discount. Relative to what? Relative to its own history and to its sector. Well, in order to have a sector, the CEFs first need to be grouped together into sectors.

So, that's the first order of business. As there are--give or take--600 CEFs with consolidations and IPOs, it's a dynamic list. And, the lists of various investors differ. For instance, you may split the list into two groups: fixed-income and equity. My list contains more than 50 sectors. It doesn't matter how finely you slice the universe, just as long as you're comfortable with your own system and that it is logical.

The second guideline that springs from my perspective of CEFs as small corporations is that any comparisons I want to perform are made within those sectors. If you invest in equities, in my experience, you won't get very far if you are not careful with your comparisons. To decide to invest in General Electric GE because its book value is far lower than that of Facebook FB, while true, doesn't really make any sense. Such a decision would illustrate a careless disregard for not only portfolio construction but also security analysis. Yet, when it comes to CEF investing, this occurs all of the time. People argue that the long-term discount to net asset value (which, of course, can be seen as price/book value) of all CEFs is 4%, and because a certain fund is trading at a 12% discount, it must be a bargain. If such folks would simply step back and look at the larger picture, they'd realize they are making a poor comparison.

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