How to Be a Discount Detective

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 Morningstar.com 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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Esser: As with any analysis, you can't only look at one data point. You have to take the context of other data points and what's going on in the marketplace into account, too, and a very recent example is a number of PIMCO funds tend to trade at very high premiums--we're talking 50%, 60%, 70%--and we often talk about how high is too high, and that absolutely is too high of a premium. We generally say never buy a fund that's selling at a double-digit premium, so 70% is just way out there.

So, there was an article recently published in Barron's that called out a lot of these funds for the high premiums that they sell at, and kind of had a spooky warning sign for investors, which was good because that's what we try to do, too. We want investors to stay away from these high premium funds.

What happened is, within about three days of the article, one fund, for example, PHK is the ticker, PIMCO High Income, went from selling at a 70% premium to a 50% premium. This is three days. So, the share price dropped about 15% over the course of three days. So, long-term investors clearly would be nervous about the share price drop of 15% over three days, and it doesn't look like the share price has stopped falling. It's continuing to fall.

So, buying funds at very, very high premiums leads to a very, very big risk that the share price will change dramatically. It has nothing to do with the underlying assets in the underlying portfolio. In addition because of this big swing in premium, the current Z-score for this fund is negative four. So, as I said earlier, that would indicate a very undervalued fund, but it's still at a 50% premium. That is still too high, obviously. It's the big swing in the premium that has made the Z-score show that it's undervalued.

So, that's why you need to look at the fund, what the market is doing, and do more research than just look at the Z-Score alone.

Glaser: It's always good to keep that broader context in mind.

This year what have premiums and discounts done? Have you seen any major trends across the space?

Esser: We have seen a general trend of narrowing of discounts and tightening of premiums, if you will. So, at the end of 2011, the average closed-end fund was selling at a 2.5% discount, and at the end of September of this year, so almost for the year-to-date, the average closed-end fund was actually selling at a premium of 0.5%, so not a huge move, but that's pretty significant in a span of nine months. In addition, historically, mostly, the average closed-end fund has been selling at a slight discount.

So, we are seeing an increase in premiums across the board, specifically in the municipal fund space. If we look at Z-scores, at the end of 2011, looking at six-month Z-scores, we had 35 funds that were considered undervalued and 51 considered overvalued. At the end of September, only 12 were considered undervalued, and 97 were considered overvalued. So, we see a trend happening over the course of this year so far.

Glaser: So, given these moves, what should investors do now? Should close-end fund investors be getting nervous about this overvaluation and what's happening now?

Esser: I think that close-end fund investors absolutely need to pay attention to current valuation. It's just like buying a stock. It might be a good stock, but it's not good at the current price.

So, you need to do your fundamental research, figure out if you like the fund, do you like the manager, do you want to invest in that fund, and then you have to look at the valuation, and maybe right now isn't the exact time to be getting into the fund, but this is when you create a watch list, and you have a target price or a target discount or premium or valuation that you think is appropriate to get into this fund.

And because we've seen the market have such a wide swings over the last year-plus, just because it's overvalued today doesn't mean it's going to be overvalued tomorrow. So, if you have your watch list and you have target prices, you can use some dips in the market as good buying opportunities. So, you just have to be more strategic about it.

Glaser: Cara, thanks so much for talking with me today.

Esser: Thanks.

Glaser: For Morningstar, I'm Jeremy Glaser.