Investors need to look before they leap into overvalued CEFs.
With the S&P 500 Index reaching new highs over the past month, many investors previously on the sidelines have begun dipping their toes back into the investment waters, however choppy they may be. Equities have been a particular favorite as credit spreads remain tight, limiting additional price appreciation for many bonds. As such, numerous fixed-income fund managers expect to simply clip coupons this year, a marked difference from the rapid price appreciation we've seen in recent years.
Now that equity markets are roaring back, timid investors are more likely to take the plunge. It's often said that individual investors have woeful market-timing skills, jumping in when markets are rapidly advancing (often entering when it's ripe for a reversal) and bailing only after they've ridden the market to the bottom--only to watch it bounce back as they wait on the sidelines.
This is especially an issue for closed-end fund investors due to the divergence between share prices and underlying net asset values. Like a stock, a CEF can be "rich" or "cheap" at a current share price, a nuance that novice investors may ignore or overlook to their own peril.
This week, we highlight 10 CEFs that have had a strong runup in share price over the last year and are currently richly valued. While some might be decent funds with strong managers, processes, and parents, as well as reasonable expense ratios, current valuations are high and investors should proceed with caution, if at all. Before we get to the list, a quick review of CEF discounts and premiums is in order. (Investors new to CEFs should take the time to peruse some of our previous articles and our CEF Solutions Center for greater detail on this very important topic.)
The basics of CEF discounts and premiums is a mathematical relationship between a fund's underlying net asset value and share price (the price at which an investor buys or sells the fund). It's simple math: if the share price is higher than NAV, a fund is trading at a premium, and if the share price is lower than NAV, it's trading at a discount. From a valuation standpoint, relative discounts matter more than absolute discounts. To measure relative discounts and premiums we use a data point called the z-score, or z-statistic, which compares a fund's current discount (or premium) to its historical discount (or premium) over a specified time frame. (You can find six-month, one-year, and three-year z-scores on a CEF's Quote page on Morningstar.com). As a rule of thumb, a z-score below negative 2 indicates a fund that is undervalued relative to historical standards and a z-score greater than 2.00 indicates a fund that is overvalued relative to historical standards.
The table below lists 10 CEFs with one-year z-scores greater than 2.00, ranked by highest z-score, as of May 6, 2013. The current discount or premium and recent NAV and share price performance data are also included.
There aren't too many patterns in the data here, and we find a mix of equity, fixed-income, and allocation funds. Four of the funds' six-month z-statistics are also above 2.00, and most others are nearing the overvaluation mark. Though not shown in the table, three funds (Mexico Fund MXF, Nuveen Diversified Dividend & Income JD, and Nuveen Senior Income NSL) are overvalued on a three-year statistical basis as well. MFS Multi-Market Income MMT is approaching overvaluation over the three-year period with a z-statistic of 1.84.
The table also points to a common misunderstanding about CEF valuations: the distinction between absolute and relative discounts. Half of the 10 funds are selling at absolute discounts. An uninformed investor may look at the 7.5% discount of Cohen & Steers Closed-End Opportunity FOF and believe he is getting a great deal. In fact, he's overpaying--the fund's three-year average discount is 8%, and during that time it reached a low of 11%.
Valuation is an important concept for CEF investors to understand before jumping into a fund. Not unlike a value stock investor, CEF investors need to be cognizant of relative value before purchasing or selling a fund. With a strong recovery continuing in the market, investors would be well-advised to look before the leap. The framework we present above provides a good starting point.
Click here for data and commentary on individual closed-end funds.
Hear Morningstar CEF Expert at Upcoming Forum
Join Morningstar on Wednesday, May 22, 2013, at The Advisor Summit on Closed-End Funds in New York City. The Closed-End Fund Association is sponsoring the event. Mike Taggart, head of U.S. closed-end fund research, will be presenting a panel on "How to analyze CEFs." Click here for the agenda and registration.