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By Jeremy Glaser and Cara Esser, CFA | 10-10-2012 11:00 AM

How to Be a Discount Detective

Closed-end fund investors should examine evidence beyond absolute discounts and premiums alone to find attractive opportunities, says CEF analyst Cara Esser.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

Discounts and premiums can be a baffling topic for new closed-end fund investors. I'm here today with Cara Esser--she is a closed-end fund analyst at Morningstar--to look at why these discounts and premiums exist and how investors can figure out if funds are truly undervalued.

Cara, thanks for talking to me today.

Cara Esser: Thanks for having me.

Glaser: So, let's start with just the basics. We hear a lot about, this closed-end fund is trending at a big premium or big discount. What does that mean, and how should people think about it?

Esser: So, jumping back to square one for new investors who are unfamiliar with closed-end funds. Closed-end funds have a share price and a net asset value. The net asset value is just like the net asset of a mutual fund. It's the value of all the underlying assets in the portfolio. Because closed-end funds are traded on an exchange, they also have a share price, and that's the price at which investors buy and sell the shares. So, the difference between the share price and the net asset value creates a discount or a premium.

Generally, discounts and premiums are linked to a fund's distribution rate. So the higher the distribution rate compared to its peers, generally these funds will sell at a higher premium or even a narrower discount depending on the field of funds that are in that universe. So, it's important to look at the absolute premium to gauge where the fund is selling at a discount or premium, but you can't look at absolute discounts and premiums alone. It's important to look at where the discount or premium is relative to the fund's own historical pattern of discounts and premiums and also to other funds within the group. With any analysis that you do, you always want to compare all your data points to similarly invested mutual funds or stocks, whatever it is that you're analyzing.

So, we use a Z-scores in our analysis to look at where the current discount or premium is relative to the fund's historical pattern of premiums and discounts, and it also takes the standard deviation of volatility of that discounted premium into account.

You can look over various timeframes. We often look at six-month, one-year, and three-year Z-scores. Those are all available on on each closed-end fund's quote page.

We would generally label a fund that has Z statistic of positive two or higher as being overvalued--meaning its current discount or premium, if it's a premium, it's higher than historical, or if its a discount, it's narrower than historical. And [we consider] a Z-Score of negative two to be undervalued. So, the opposite of what I said--the premium is either lower, or the discount is wider.

Glaser: So, certainly it's not as easy as saying, hey it's trading at a big discount, and therefore, it's a good deal. It might not necessarily converge. It could trade at discount for an incredibly long time.

What's an example of time when maybe the Z-score wouldn't be the most effective way to determine this?

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