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Eight Closed-End Funds That Currently Look Extremely Undervalued

These CEFs are currently trading at significant, attractive relative discounts.

Mike Taggart, CFA, 05/31/2013

The discount/premium phenomenon of closed-end funds, or CEFs, is a big attraction to many investors. We have cautioned, though, on many occasions that the actual discount/premium isn't as important an indicator as many would suspect. At the end of the day, all the discount or premium tells you is the mathematical relationship between two values, the net asset value and the share price. If you sell a fund at $10 per share and a 9% premium, there's no guarantee that the fund's NAV isn't going to go to $15 and the share price to $20. Once you're invested, all you should care about is your total return and the prospects of the net asset value, with the premium--or overvaluation of the share price relative to the portfolio value--being a secondary consideration.

Another problem with discounts is that they tend to persist. That equity fund you are considering buying because it has a 15% discount likely has had a roughly 15% discount for the past three years. There is nothing that says a discount needs to collapse to 0%.

A better way to discern value in CEF discounts is to look at the relative discount. Regular readers will know that articles on this subject are littered throughout our CEF Weekly Article Archive. We also have a presentation on relative discounts in our Solutions Center. Essentially, a relative discount tells you where a fund's current discount is relative to where it has been over any given time period. To get an even better handle on relative discounts, it's also informative to look at a fund's current discount relative to its peers' discounts. So, for instance, if you have a fund invested in bank loans, it might be interesting to see where it trades to other bank-loan CEFs. Again, the time frame matters. We tend to look at short-, intermediate-, and long-term periods.

But sometimes the relative discount compared with the fund's own discount history is very compelling.

Relative Discounts
Relative discounts are measured using z-statistics. The formula is very easy: You take the current discount, subtract the average discount over a period, and then divide by the standard deviation (volatility) of the discount over that same period.

z-statistic = (current discount – average discount)/standard deviation of discount

The z-statistic result is the number of standard deviations away from the average discount over the period measured. So, a z-statistic of -2 would mean the fund's current discount is two standard deviations below where it has averaged over the period. A z-statistic less than -2 standard deviations or greater than +2 standard deviations would be expected to occur, assuming a normal distribution of discounts, about 2.3% of the time over the long run. Typically, we assume a z-statistic less than -2 means a CEF is currently undervalued and a z-statistic above +2 means a CEF is currently overvalued. We highlight such funds in our weekly update. All of this assumes a normal distribution of discounts, which isn't really the case but the results--identifying undervalued and overvalued CEFs--seem to work despite this flaw.

Eight CEFs Trading Three Standard Deviations or More Below Their One-Year Average
It's rare, though, that we see z-statistics for a one-year period deviate more than three standard deviations from the average discount. This would only be expected to happen in 0.1% of occurrences. Today, though, there are eight funds trading with relative discounts of -3 or lower. These CEFs are listed in the table below in the order of their one-year z-statistic.

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

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