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By Samuel Lee and Jeremy Glaser | 11-21-2013 10:00 AM

Discounts Make These CEFs the Cheaper Option

ETFInvestor editor Sam Lee says Fed-taper fears have forced several closed-end funds to trade at discounts compared with ETFs or mutual funds of similar strategies.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Sam Lee. He's the editor of Morningstar ETFInvestor newsletter. We're going to look at closed-end funds, an area he has started to look more at, and see how they compare with exchange-traded funds.

Sam, thanks for being here.

Sam Lee: Glad to be here, Jeremy.

Glaser: You've recently started looking at closed-end funds in your newsletter along with ETFs. Can you explain some of the similarities and differences between these two structures?

Lee: The closed-end fund is actually the oldest investment company structure in existence. It's very simple. It just issues shares, and it uses the proceeds from those shares to buy investments and assets. And there's no necessary linkage between the net asset value of a closed-end fund and the market price of its shares. Those two tend to be somewhat similar, but they can deviate considerably for long periods of time.

The ETF is very much like a closed-end fund, except it has the ability every day to create and redeem shares. So, there's an incentive for arbitragers to come in and shrink that premium and discount. So, the closed-end fund and the ETF are very, very similar cousins. One is the older, simpler structure out there, and the other is arguably the new investment structure out there. But they share a lot of similarities. Naturally, I thought that, if I'm looking at ETFs, closed-end funds are interesting candidates, especially because a lot of them are trading at interesting discounts today.

Glaser: Given that you do have this premium/discount issue with closed-end funds that doesn't exist as much with ETFs, why would CEFs look interesting? When do these discounts start to look compelling?

Lee: Discounts tend to widen when there's a period of market stress or when retail investors are very scared. Closed-end fund investors are not institutional. The entire market is about $300 billion, less than that, and that's actually smaller than some of the mega-cap companies in the S&P 500. With Exxon Mobil and Apple, you have nearly $500 billion companies. Closed-end funds are a very tiny niche part of the market, very fragmented, very illiquid, and largely owned by individuals.

The prices of these closed-end funds can deviate from their fair values either on the upside, that is irrational premiums or irrational discounts. Now that I think some of them are trading at irrational discounts, I thought that now is a good time to begin buying closed-end funds opportunistically.

Glaser: How do you know when you're finding a fund trading at irrational discount versus a discount that might persist indefinitely?

Lee: One good sign is if the discount has lasted a very long time, over many different periods and the discount has been fairly constant: The market price and the net asset value move in sync. And that suggests that the market has set a fair discount to this closed-end fund, either because of tax issues, management issues, or fees. An irrational discount is one that has widened in relation to its history by a considerable amount. A lot of times, you can actually see these irrational discounts when they go from premiums all the way down to discounts, and we saw that with a lot of high-yielding funds, starting in June of this year.

Earlier, we had investors stretching for yields, and when [Fed chairman Ben] Bernanke said, we might start tapering later on this year, that sent everyone fleeing out of duration [a measure of interest-rate sensitivity], and retail investors, being the flighty sort, sold en masse. You saw a lot of these premiums go down to considerable discounts, and I think that is a clear indication that this is largely an irrational move by retail investors.

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