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2 Temptations That Trip Up CEF Investors

Proper comparisons can help you avoid missteps.

Mike Taggart, CFA, 03/15/2013

In last week's closed-end fund article, I discussed two ramifications of my perspective that CEFs are more akin to corporations than to mutual funds. First, just as you probably wouldn't compare an Internet company with an industrial company, we need to be aware of what CEFs' underlying portfolios--their businesses--contain. Second, after we group the CEFs by their underlying portfolio characteristics, we can make proper comparisons. We don't want to make large, absolute comparisons of one CEF against the CEF universe or compare a state municipal CEF with a large-cap growth equity CEF.

Let's see how this works in practice.

Assume that you are a resident of Massachusetts and have decided that your portfolio would benefit from more exposure to Massachusetts municipal income. You've narrowed your fund selection process down to the six CEFs that offer Massachusetts municipals. But, now what?

In my experience, most investors would simply reach for the fund offering the highest distribution rate, or yield, at share price. In this case, that would lead to Eaton Vance MA Municipal Income MMV. But, let's step back. If you were investing in a blue-chip equity, would you simply purchase the company offering the highest dividend yield? Wouldn't you first want to know how that yield is generated and, as a close second question, how sustainable that yield is?

For CEFs, it is best to start with the distribution rate at net asset value. This gets us a little closer to how the distribution is generated. From the table above, we see that MA Health & Education MHE actually offers the highest distribution rate at 5.30%. Backing out the leverage effects of each fund, we can further see that the stripped-down NAV distribution rate of 3.84% is the same as that of Eaton Vance MA Municipal Income. So far, so good. But, there are four things to consider. First, MA Health & Education is trading at a 5.95% premium, reflecting the fact that other investors have jumped aboard the income train. Second, unlike the other five funds, this fund's latest portfolio holdings show only a very small allocation to credits rated AAA; a lot of this distribution comes from accepting more credit risk. Third, to capture yield, the managers are willing to buy underlying bonds at high premiums to par. So, in addition to fund investors paying a premium, the portfolio itself is at a premium. Fourth, four of the six funds have recently lowered their distribution rates, with MA Health & Education and Eaton Vance MA Municipal Income being the holdouts. Given the small size of the funds' investable universe, I wonder how long they can continue to hold out. It bears more digging.

Suddenly, Nuveen MA Premium Income Municipal NMT starts to come into the foreground, at least for me. True, it's only offering a distribution rate at NAV of 4.36%. Bear in mind, the distribution rates mentioned for municipal funds are not tax-equivalent rates. But here we have a fund trading at a 5.30% discount to NAV. The portfolio itself bears a 10% premium to par--nearly the lowest in the group. About one fifth of the total assets are in AAA rated securities and nearly two thirds are in AAA or AA rated bonds. And the fund just lowered its distribution rate. Given that Nuveen is considered a conservative fund sponsor and given its history with distributions, this offers some assurance that the distribution rate will not be reduced in the next few months.

We could delve further, looking at such metrics as call exposure, duration exposure,  leverage costs, etc. But I think the point is clear: Finding a suitable investment requires more than simply choosing the fund with the highest distribution rate. Note that there was no comparison with municipal CEFs in general or with the CEF universe. To me, the closest approximation in equities would be comparing a small group of regional banks to decide which one to invest in for yield. You wouldn't compare with all financials or with the global banks. You'd keep the peer group tight and focus on the underlying characteristics of the business model that allow the yields to be paid. 

If you come at CEFs from an equity perspective, one of the first things you'll likely realize is that the discount/premium phenomenon is nothing more than a price/book ratio, with NAV playing the part of book value. Instead of stating the relationship as, for instance, "the fund is trading at a price/book value of 0.9," we state it as "the fund is trading at a 10% discount." They mean the same thing.

Now, imagine if someone came to you and said, "I don't do any fundamental analysis. I simply buy any equity trading at a price/book ratio of 0.85 or less and then wait until the ratio hits 1. That's when I sell." Such a statement would be ludicrous in the extreme. Nobody would set out to invest in such a manner. Yet when it comes to CEF investing, how often have you heard or read that you should only buy CEFs trading at a discount of 15% or more? The two statements are the same.

Let's now imagine some stocks that trade based on book value--most stocks, as you are no doubt aware, instead trade on earnings or cash flow metrics. One of the stocks in this group is trading at nearly 0.8 times book value, the others are trading at 0.9 times book value. I don't know about you, but the first thing that pops into my mind is, "Why does one trade for a lower value?"

At least once a week these days, I am asked what equity fund is trading at the biggest discount. My questioner is almost always a journalist, but I get emails from brokers and individual investors asking the same thing. The point of their questions is to find something undervalued, but they are missing the mark.

In the table above, it is obvious that the "company" trading at a lower valuation than its peers is Central Securities CET, which actually is an internally managed fund--a corporation in the true sense of the word. So, is it the best bargain of the group? Perhaps, although the reason for its lower valuation is likely the portfolio's tremendous unrealized capital gains stemming from having nearly 33% of its holdings in a privately held insurance company. Sure, it has the largest discount among CEFs focused on mid-cap equities. That doesn't necessarily mean the share price is offering up any value.

Often, though, stock investors can find value when a stock is trading far beneath where it typically trades on a valuation metric. For instance, if Central Securities typically traded at 1.1 times book value, and then inexplicably or for no fundamental reason its valuation fell to 0.8 times book value, then we might be interested. To get at this possibility from a CEF perspective, we use z-stats, which simply tell us how rare it is for a discount, or premium, to exist at these levels. A z-stat of 0 signifies that the current discount is equal to the average discount over the time period, whereas a z-stat of negative 2 would indicate it is two standard deviations lower than average over the time period. For Central Securities, the discount is a little lower than where it has been over the past six-months and year. Still, at these z-stat levels, it's nothing to write home about.

How can you use this information? Well, let's say that the share price of Liberty All-Star Growth ASG falls off the table next week. Something crazy happens and the stock tanks but the NAV doesn't change. As a result, it's discount collapses to 20%, it's six-month z-stat stands at negative 3, and instead of having one of the tightest discounts in the group, it has one of the widest. At that point, you'd dig into the fund a bit to make sure no news came out, there is nothing untoward in regulatory filings, etc. And then, you could state unequivocally that the fund was cheap compared with its historic valuation and its group valuation.

You also can use the sector valuations as a whole. Most clearly, I remember back in August 2011 when the U.S. Federal Reserve announced that its interest policy would be in effect for years, and the resulting sell-off for senior loan funds was tremendous. Senior loan funds went from trading at a 5% premium to a 10% discount in a matter of days. Savvy, patient investors saw this, understood that such valuations represented good value, and bought.

I hope this view of CEF investing from an equity-investing perspective has helped. It's not enough to discuss CEFs as if they are an asset class or as if they all do the same thing. They are unique funds that are best viewed alongside funds with similar underlying portfolios and strategies. Once they are properly grouped, more enlightened questions can be asked and better investment decisions can be made. When it comes to income, the smartest decision is often to skip the fund with the highest distribution rate. When it comes to investing for the discount, the persistent exercise of patience is key.

Click here for data and commentary on individual closed-end funds.

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

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