Purchasing strong funds at good relative valuations is crucial when investing in closed-end funds.
In the context of fund investing, conversations of growth versus value often refer to the underlying strategy implemented by fund managers. While these are important distinctions for all fund investors to understand, closed-end fund investors also need to consider the valuation of the fund itself before trading shares.
A completely unscientific poll of our active discussion board members shows that many are value-oriented investors, making buy and sell decisions based on current and relative valuations. Of course, the fundamentals of the underlying fund matter, and long-term investors should look for bargains on funds they believe are worthy candidates that fit in their well-diversified portfolios. There are some CEF investors, however, that play a trading game, looking solely for dislocations in valuation for short-term trading profits.
At Morningstar, we take a long-term view. Our Morningstar Analyst Rating for Funds is a qualitative assessment of our conviction of a fund's ability to outperform over a market cycle. We've also been outspoken about the importance of valuation analysis before adding CEFs to any portfolio. Coupling our Analyst Ratings with a valuation analysis can uncover strong funds selling at attractive valuations. This week, we highlight 10 funds with positive Morningstar Analyst Ratings that are at or near undervaluation on a one-year statistical basis.
Morningstar Analyst Rating for Funds
Before we get to the list, a quick overview of the Morningstar Analyst Rating for Funds is in order. The rating is qualitative and separate from the Morningstar Rating for Funds (the "Star Rating"). It is based on Morningstar's conviction in a fund's ability to outperform its peer group or relevant benchmark on a risk-adjusted basis (for CEFs, we consider net asset value performance, not share price). The rating is built around five pillars that we believe inform future performance: People, Parent, Process, Performance, and Price. Unlike the Star Rating, which relies solely on historical risk-adjusted performance against a peer group, the Analyst Rating is forward-looking. Historical performance plays a minimal role in the rating, with the focus on a fund's managers, investment process, and parent firm. There are three positive ratings (Gold, Silver, and Bronze), a Neutral rating, and a Negative rating. The degree of conviction decides which positive rating a fund may get, but the ratings are not designed to predict that a Gold-rated fund will outperform a Silver- or Bronze-rated fund.
Last week, we highlighted 10 overvalued CEFs and included a short discussion of the z-statistic, a valuation measure we use to put current discounts and premiums into historical context. We will recap the same summary here for those who did not read last week's article. At the heart 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 is 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 the z-statistic, or z-score, which compares a fund's current discount (or premium) with 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 2.00 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 recovering market and growing interest in high income-distributing investment vehicles has made it difficult to uncover truly undervalued funds. But the recent falloff in the bond market has helped. At the close of last week (May 10), there were only seven undervalued funds in the entire CEF universe (596 funds in sum), but as of May 15, 39 CEFs had one-year z-statistics less than or equal to negative 2.00. For a simple valuation trade, this may be all the information an investor needs, but a long-term-oriented investor needs to consider the quality of the fund before blindly buying shares.
The table below lists 10 CEFs with positive Morningstar Analyst Ratings that have one-year z-statistics below or approaching negative 2.00. The table is ranked by lowest z-score and also includes the current discount or premium and recent NAV and share price performance data.
One of our top-rated funds, Aberdeen Asia-Pacific Income FAX, has the lowest valuation of the group based on the one-year z-statistic. Though some investors have jumped ship as returns have slowed a bit over the last year, the current 4.0% discount is not far out of line with its three-year average discount of 2.2% (the three-year z-statistic is negative 0.74, in the fair value range). We still believe the fund is worthy of its rating, despite the recent dip in returns. The temporary falloff in price presents interested investors with an opportunity to purchase shares at an attractive valuation.
While the equity market has been on a tear recently, the price of gold and other precious metals has plummeted. Three CEFs investing in gold and silver have seen widening discounts as share prices have fallen much faster than underlying NAVs. Central GoldTrust GTU, Central Fund of Canada CEF, and Sprott Physical Gold Trust PHYS are unleveraged funds investing in precious metals. Central GoldTrust and Sprott Physical Gold Trust hold only gold bars and bullion, while Central Fund of Canada holds both gold and silver bars and bullion. These funds were widely popular during and shortly after the financial crisis as investors rushed to the perceived safety of precious metals. Their popularity remained high as fears of inflation took hold, but the recent fall in gold and silver prices has widened the discounts of the three funds. In fact, over the last six months, the funds were selling at premiums until the recent dislocation in share price. Central GoldTrust and Central Fund of Canada are both undervalued on a one-year statistical basis, while Sprott Physical Gold Trust is nearing undervaluation with a z-statistic of negative 1.97.
Finally, many municipal CEFs are currently selling at appealing valuation levels as the market has sold off a bit. During the last few years, investors hungry for tax-advantaged yield have sought out municipal funds, pushing many to levels of overvaluation. The remaining six funds on the list are some of our favorite muni funds and all are nearing undervaluation on a one-year statistical basis. Current valuation levels are not as attractive as a few months ago, but they remain appealing nonetheless, especially for investors seeking tax-advantaged income.
Though CEF investing can be more complex than investing in a traditional mutual fund, the ability to snag a good fund at a cheap price provides an opportunity for increased returns. We encourage CEF investors to think like value investors by creating a watchlist for funds of interest, purchasing shares when valuation levels are attractive, and avoiding richly priced funds.
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