Rule 1: Do not look simply at published discounts to determine valuation.
T.S. Eliot wrote that "April is the cruellest (sic) month." While that may be true for poets and academics, for closed-end fund investors this year, late May and early June were the cruelest. Indeed, the fright that overtook some investors in fixed-income CEFs is quite apparent by looking at average discounts. Taxable fixed-income CEFs averaged a 0.12% discount at the end of April, a 3.55% discount at the end of May, and an average 3.63% discount at the end of June. Investors in national municipal bond CEFs saw the average discount widen from 0.87% at the end of April to 5.03% at May's finish, before settling back to 2.73% at the end of June. For state municipal CEFs, the average discounts were, respectively, 1.49%, 5.48%, and 3.07%. As reflected in these numbers, the markets have been on quite the emotional roller coaster ever since Federal Reserve Chairman Ben Bernanke mentioned "tapering" the Quantitative Easing program.
It was in the midst of the recent market turmoil that I found myself moderating a panel of opportunistic CEF investors at the Morningstar Investment Conference. Patrick Galley of RiverNorth Capital and portfolio manager of, among others, RiverNorth Core Opportunity RNCOX, John Cole Scott of Closed-End Fund Advisors, and Rob Shaker of Shaker Financial Services joined me on the dais to discuss CEFs. All three are "opportunistic" in the sense that they patiently wait for abnormally wide discounts to emerge, buy such shares, and sell when they believe the discount has tightened significantly. I'm paraphrasing, but below I'll delve a bit into their strategies. Needless to say, given what was going on in the markets, much of our time was spent discussing how investors can better use discounts to take advantage of market sell-offs.
Buy and Hold?
While all three of these professional investors are more trader than long-term investor, Shaker had a really poignant, concise point for buy-and-hold investors. "The important thing to remember is, if you are going to buy and hold, you need to remain faithful to that idea." Pointing to the widening discounts that were ongoing at the time, he stated "this is not the time to sell. This is the time to buy and to hold what you already own because, before you bought, you knew this kind of volatility was possible."
Shaker is a guy who speaks his mind, which is one of the reasons I was so pleased to invite him onto the panel. Truer words about investing in CEFs could not be spoken. CEF investors need to know what they're buying and how leverage will magnify their fund's volatility. But, unfortunately, time and again, in market sell-offs we see the discounts widen out significantly and quickly. I'm quite sure that this will always happen. Discounts and premiums for closed-end funds are nothing but a barometer of CEF investors' collective greed and fear; in fact, it is well-known that the average discount for all closed-end funds is highly correlated to the S&P 500 Volatility Index, or VIX, more popularly known as "the fear index."
Shaker's points are true. Investors should know, before they buy shares, what they're getting into. The sad fact is that most investors don't do their homework and rush to sell their shares when the first dark cloud appears on the horizon. Forgetting that most CEFs are akin to micro-cap stocks with very thin trading volumes, they race for the exits, sending their CEF share price down faster than the underlying NAV decline. The discount widening engenders more fear, which leads to more selling, until the vicious cycle eventually wears itself out. While such timid investors are busy dumping shares, the three men on my panel are on the other end, buying shares at bargain-bin prices. Hopefully, reader, you will do the same. Buying when there is panic all around has been a solid long-term investment strategy at least since the Rothschilds employed it in the early 1800s.
Buy when there are market dislocations and discounts widen significantly, knowing full well that there will be future market downturns, and hold on through those downturns. That's CEF investment wisdom right there.
Discerning When a Discount Is Enticing
The offices of RiverNorth Capital are only a few blocks from Morningstar's Chicago headquarters. Unsurprisingly, I met Galley very soon after reviving Morningstar's CEF research presence in 2010. Since then, I've tried countless times to learn the secret ingredient that he and co-portfolio manager Stephen O'Neill employ in choosing CEFs for their portfolio. When you're the manager of a long-term 5-star rated mutual fund, you hold your cards close to your chest. So, of course, I'm never going to succeed in my endeavor. Galley, though, was very forthcoming to our audience, as were Scott and Shaker.
Their approaches can be combined and paraphrased as follows. They don't look at published discounts and premiums. They don't care that a fund is trading at an 8% discount. As Galley said, "we don't just buy the funds with the largest discounts because there's probably a reason why a fund has a 15% discount."