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Discounts Make These CEFs the Cheaper Option

Samuel Lee
Jeremy Glaser

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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Glaser: A lot of CEFs use leverage. Is that something that concerns you when looking at these funds? How does that factor into your analysis?

Lee: Yes. That's definitely something investors should be concerned about. Leverage is borrowing to juice their returns. A lot of closed-end funds live or die by their distribution yield, and the way companies get that yield up is they borrow money to the hilt. Closed-end funds are the perfect vehicle for leveraging because they have a fixed asset value. They're not subject to the whims of investors suddenly yanking out their money. A lot of closed-end funds do take advantage of that. One downside is that sometimes when the market goes down and creditors begin withdrawing liquidity and leverage from the market, closed-end funds might be forced to pare down their leverage and sell their assets, and this is what we saw in late 2008, early 2009.

A lot of closed-end funds were leveraged to the hilt in some very high-yielding risky assets, the least liquid kind. And when the financial crisis hit, and everyone started issuing margin calls, all the creditors started issuing margin calls, these closed-end funds were forced to sell their assets at fire-sale prices. If you look at the net asset values of a lot of these funds, they never quite recovered even though the high-yield market did recover. That's because of the permanent impairment of capital from selling your assets at hugely discounted prices.

Glaser: Given all of this, what closed-end funds are you finding attractive right now?

Lee: I tend to look for closed-end funds that have an analogous strategy in an ETF or mutual fund format because it's very clear when this closed-end fund is trading at a steep discount or has certain attractive features that make it superior to the ETF or the mutual fund version. One example is gold. There are closed-end funds mostly based in Canada that own physical gold, and one of my favorite right now is the Central GoldTrust Common shares, ticker GTU. That, I think, is very compelling because it's trading at about a 7.5% discount to net asset value, and net asset value is just simply the price of gold.

Whereas you have ETFs that are trading just that around net asset value that don't have a premium or discount. I think if you own gold in the ETF format, it might make sense to sell out of it. You harvest your losses and buy this closed-end fund version of it. The closed-end fund, granted, does have a 35-basis-point expense ratio. So it's a little bit pricier, but I think the 7.5% discount more than makes up for it.

Glaser: What are some other CEFs you find attractive right now?

Lee: Another one is Templeton Global Income, ticker GIM, and this one is the closed-end fund version of the Templeton Global Bond mutual fund, ticker TPINX. It has a couple of interesting advantages. One is that, it's trading at a discount, so you get the same strategy or something very similar to it at about a 6% discount at current prices, and it has a lower expense ratio.

The mutual fund has an expense ratio of 86 basis points, whereas the closed-end fund, ticker GIM, has an expense ratio of only 73 basis points. You're getting the same strategy at a discount and with a lower expense ratio. I think it's more interesting because it takes bigger currency bets, so it's a slightly leveraged version of the mutual fund.

If you really believe in the Templeton Global Bond fund and you like manager Michael Hasenstab and his process--the fund is Gold-rated by our analysts--then you should definitely consider swapping out the mutual fund for the closed-end fund version.

Glaser: Anything else?

Lee: And one more, this one is more speculative, but it's one of my favorite funds right now, and it's PIMCO Dynamic Income, ticker PDI. This one is kind of scary because it's highly leveraged, it charges a pretty big expense ratio, and it has very unusual assets.

Right now, it charges close to 3% if you include leverage costs on a leverage-adjusted basis. If you exclude leverage costs, it charges about 2%, and that's a huge expense ratio. I'm an ETF guy. I am used to paying 5 basis points. So going up to 200 or 300, I need a heck of a good reason, especially when it's a more leveraged, more speculative fund like this one.

The reason why I like it is simple, it's because the manager, Dan Ivascyn, has staked $11 million of his own personal wealth into this fund. For him to put $11 million into this highly expensive closed-end fund, I think, is a very interesting signal. I think it's especially interesting because Dan Ivascyn runs this fund, so, a lot of his human capital is exposed to this funds' performance. And he's taxed at almost the highest tax rates, and that to me suggests that if he's willing to take on this human-capital-concentration risk and pay huge fees, huge taxes on this fund, then he has a very good inside information as to what this fund holds. And he's very comfortable with those holdings.

Dan Ivascyn is pretty well-known because he runs the PIMCO Income mutual dund, ticker PIMIX, and it runs a very similar strategy to the closed-end fund. But because this PIMCO Income fund I think it has more than $30 billion in assets right now, it's not able to hold the most interesting opportunities. Dan Ivascyn has only about $500,000-$100,000 of his own personal assets in PIMCO Income. Whereas he has $11 million in this closed-end fund version that runs a more concentrated strategy. So, he has discretion over which bonds go into which funds. If he comes across a really interesting undervalued opportunity, he's incentivized to put it into the closed-end fund and not put it into the gigantic mutual fund, which it wouldn't make a difference anyway.

Right now, [the closed-end fund] seems to be concentrated heavily in nonagency mortgaged-backed securities. These are the junkiest of the junk mortgage-backed securities that aren't backed by any government guarantees, and they were bombed out during the financial crisis. So, everyone sold mortgage-backed securities because housing prices were going down, people were defaulting on their loans. These were some of the most unloved and also some of the most illiquid assets. They were sold off heavily.

Now that the housing market is recovering, the collateral backing these mortgage-backed securities is becoming increasingly more valuable, and because this market is very illiquid and because real estate is a very local market, it requires a lot of research and a lot of heavy-duty security analysis to identify the most interesting opportunities. I think that PDI, right now, has the ability to do that because it has about $1 billion in assets. So, it's able to concentrate on some of these best-idea mortgage-backed securities.

Glaser: Sam, thanks for your thoughts on CEFs today.

Lee: Glad to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.

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