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By Mike Taggart, CFA | 11-11-2011 12:17 PM

Look Beyond CEF Discounts

The discount a CEF is trading at versus its net asset value is only the starting point to creating a successful portfolio, says CLC Management's Tony Cutinelli.

Mike Taggart: Hi, I'm Mike Taggart, director of U.S. closed-end fund research at Morningstar. With me today is Tony Cutinelli, who is a partner and portfolio manager at CLC Management, where he has been investing in a closed-end-fund-focused strategy since October 2002.

Tony, thanks for joining me.

Tony Cutinelli: Thank you, Mike. Thanks for having me.

Taggart: Now, Tony, you've put up what I think is a pretty nice track record, with an annualized performance of just under 9% since inception through your long-short strategy.

I've been wanting to bring you over here, since you are based in Chicago, just so you could help maybe shed some light for our viewers as to how you've put together that track record. So, what's the first step?

Cutinelli: The first step is we do a lot of historical analysis of the discounts and premiums at which closed-end funds trade. There tends to be an average, so a dramatic discount or dramatic premium doesn't necessarily initiate an investment in that security.

We're looking for a deviation from the norm of that average discount or premium to create an interest for us. We'll do screens using Morningstar's database as one of our tools. When we find a significant deviation from the norm, we then go in and do a little more in-depth analysis based on about 10 or 12 different criteria to see if it merits an investment.

Taggart: So, it sounds like you use a relative-discount strategy, which is something that we support in terms of looking at a way of figuring out which funds are what we call overvalued or might be undervalued.

Then, obviously, the time period that you use is different. On our website we provide six-month, one-year, and three-year Z-statistics to figure that out. We consider something that's below negative 2.5 standard deviations to be undervalued and above positive 2.5 to be overvalued.

Cutinelli: We use something very similar to that. The one thing we do overlay is the interest-rate environment at the time; if we're in a neutral-rate, rising-rate, or declining-rate environment, that affects what that relative discount historical is.

Taggart: Now, just like with stocks, if you see a P/E ratio, a PEG ratio, or whatever the metric is, that's kind of the first step. You've mentioned some other steps that you do for your due diligence.

Cutinelli: Right. When they come up on a screen, we'll then go in, we'll look at the earnings power of the fund, whether they are earning their dividend or not, whether there is any undistributed earned income, what the track record of management is, what sector are they in, and what the underlying fundamentals of that sector are.

There is a lot more work that goes into it. It's only after we've gone through that that we make a decision whether it's worthy of an investment. If it is, in our case, we often look to find a similar fund trading at the opposite end, whether it would be overvalued or undervalued as a hedge to the position we put on.

Taggart: Right, because you are long-short, as I mentioned, so you want to take that short position. So, it sounds like just to kind of reiterate this, just because you see something that might look attractive, that might look undervalued or overvalued, when you do the due diligence you aren't just jumping in there and buying it?

Cutinelli: No, it could take quite a while to work through the data or we could find that there is a potential there, but we want to see the discount potentially go out even further, to make us more confident that the risk is priced into the issue.

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