Morningstar’s Top Tips For Investing in CEFs
Investors willing to take the time to learn the ins and outs of CEFs will discover a relatively unfollowed and often mispriced slice of the market.
Many investors aren't familiar with closed-end funds, or CEFs. Some investors who are somewhat familiar with CEFs may view them as overly complex, believe they're difficult to use, or dismiss them with a "those things are just wacky" type of comment. While it is true that CEFs are structurally more complex than exchange-traded funds and open-end mutual funds, investors willing to take the time to learn the ins and outs of CEFs will discover a relatively unfollowed and often mispriced slice of the market. Whether you're new to CEFs or an old pro, here are some of our best tips to make investing in CEFs a better experience. The following are excerpts from Morningstar's Guide to Closed-End Funds, which is available to subscribers of Morningstar Direct.
Just Say No at the IPO
It is often said that CEF IPOs are sold, not bought. At Morningstar, we believe that most investors should avoid purchasing shares of a CEF at the IPO, mainly because of the "CEF IPO Premium" phenomenon caused by the high commissions paid to brokers for selling shares and the absence of a fiduciary standard applied to those brokers.
From a nuts-and-bolts perspective, launching a new fund isn't free--there are legal, filing, and underwriting fees, and investors have traditionally been on the hook for those fees. Mathematically, this means that all CEFs trade at premiums at the IPO. Exhibit 1 shows a hypothetical CEF IPO. For simplicity, assume the CEF sells a single share, which means the fund's manager starts with $25 (the price of one share). After paying underwriting and other fees ($1.19 in this example), the manager has $23.81 to invest according to the fund's strategy. This investor just paid $25 for $23.81 worth of assets and has experienced the "CEF IPO Premium" phenomenon firsthand. Premiums aren't necessarily bad, but IPO premiums tend to dissipate within a few months of a fund's launch, generally leading to a loss for shareholders who purchased shares at the IPO.
Participating in Rights Offerings Is a Must
Rights offerings allow existing shareholders to buy a proportional number of shares, based on how many they currently own, at a discounted price. Rights can be both transferable (meaning they can be traded on an exchange) and nontransferable. Shareholders have the right, but never the obligation, to buy the additional shares. If an investor likes the fund and wants to allocate more capital to it, exercising a rights offering is a no-brainer--simply subscribe to the offering and purchase additional shares. But many investors will not wish to allocate more capital to the fund. By not participating, however, their stake in the fund is diluted. This is because additional shares are sold at a discount to market value, which increases the number of shares outstanding by more than the assets in the fund. Exhibit 2 illustrates the dilution.
Fund XYZ has two shareholders (A and B), and each owns three shares at $10 per share. Fund XYZ's total market value is $60. The fund implements a 1-for-3 rights offering (allowing each shareholder to purchase one additional share) at 90% of the market price of $10. Shareholder A participates in the offering, purchasing an additional share for $9, but Shareholder B does not participate.
Post-offering, the fund has seven shares outstanding and a market value of $69--the original $60 market value plus the $9 from Shareholder A's single-share purchase (note that numbers are rounded for simplicity). With a total market value of $69, each share is worth $9.86 per share--the total fund value divided by the number of shares outstanding. Shareholder A's position is now worth $39.40 (four shares at $9.86), compared with the pre-rights offering value plus the additional share purchase of $39 (three shares at $10 and one at $9). Shareholder B's position is worth $29.55 (three shares at $9.86), compared with the pre-rights offering value of $30 (three shares at $10). By not participating in the offering, Shareholder B's stake is diluted.
To avoid dilution without committing additional capital to the fund, investors have a few options. The simplest transaction is a transferable rights offering. The right to buy shares has intrinsic value and represents a distribution to shareholders. Assuming efficient markets, transferable rights can be sold on an exchange, generating additional investment income to offset any post-offering price decline. The investor simply sells the rights on the open market to another investor who then purchases shares at the discounted, rights-offering price. The value of the rights on the open market (the price the initial investor receives for the rights) is equal to the drop in share price because of the rights offering's dilution of shares.
Absolute Discounts Can Lead Investors Astray
The CEF discount and premium phenomenon can get an uninformed investor into trouble. A less informed investor may look at a fund selling at a 5% discount and think it is a great deal--after all, he can buy $10 worth of assets for $9.50. But that discount may never reach zero, and, even if it does, an absolute discount can close for many reasons, and only some will benefit the investor. Take a fund with a share price of $15, a net asset value of $20, and a subsequent discount of 25%. Exhibit 3 shows nine mathematical ways in which this fund's discount can change.
Because a discount is simply a mathematical relationship between share price and NAV, it can narrow for many reasons. First, the NAV may remain steady and the share price indeed rises toward the NAV. This is positive for the investor. Second, the fund's share price can rise while the NAV drops (in this example, the share price jumped to $18 while the NAV dropped to $18). Despite a realized gain, long-term investors should be concerned that the underlying portfolio is heading south because the long-term share-price return relies, at least in part, on the portfolio's performance.
The remaining scenarios of discount-narrowing may or may not benefit the investor. If the NAV drops and the share price remains stable, the discount narrows but the investor realizes no profit. If both NAV and share price drop or both NAV and share price rise, the discount may narrow. The above example shows a narrower discount when both share price and NAV rise and a wider discount when both drop, but this will not always be the case. The fund's NAV can fall less than the share price, narrowing the discount, or the NAV can rise slower than the share price, also narrowing the discount.
It is important to remember that discounts and premiums are simply names given to a relationship between the share price and the NAV.
Exhibit 4 shows the three-year average discount for taxable-bond, equity, and muni CEFs.
The average muni CEF was trading at a slight premium at the end of the month. It's the first time the average fund has traded at a premium since early 2013. The share prices of muni CEFs have been driven higher by strong demand for tax-free yields amid the continued sinking of interest rates. Taxable-bond CEFs have rallied, too, but still remain at an average discount of close to 3%. That's still an improvement over the almost 10% average discount at which they began the year. Taxable-bond CEFs tend to take on more credit risk than muni CEFs, which could help explain why they haven't rallied as close to par, with concerns over the strength of the economy being a key driver of the lower yields.
Measuring Relative Discounts and Premiums Using Z-Statistics
Paying too much attention to absolute discounts and premiums can lead to the CEF equivalent of investing in an equity value trap, hence, the importance of using relative discounts and premiums. We use a z-statistic to measure whether a fund is "cheap" or "expensive." As background, the z-statistic measures how many standard deviations a fund's discount/premium is from its three-year average discount/premium. For instance, a fund with a z-statistic of negative 2 would be 2 standard deviations below its three-year average discount/premium. Funds with the lowest z-statistics are classified as relatively inexpensive, while those with the highest z-statistics are relatively expensive. We consider funds with a z-statistic of negative 2 or lower to be "statistically undervalued" and those with a z-statistic of 2 or higher to be "statistically overvalued." That said, the z-statistic does have its flaws.
Exhibit 5 shows the most over- and undervalued CEFs as of Aug. 3, 2016.
With the average CEF discount narrowing throughout the year, it's not surprising to see a number of CEFs start to look richly valued. BlackRock's muni CEFs, for example, have drawn considerable interest from investors this year. BlackRock Muniyield Investment Quality (MFT) had traded at a three-year average discount of 8%, but as of early August, the CEF was trading at a 4% premium. It started the year at a close to 5% discount, so investors have gained nearly 10% through the discount narrowing. Although it didn't crack the 10 most overvalued CEFs, PIMCO Global StocksPLUS & Income (PGP) deserves an honorable mention. As of Aug. 3, the CEF was trading at a 105% premium to its net asset value. It has typically traded at a steep premium, the three-year average is 65%, but paying twice the price of the fund's underlying value seems especially absurd even for a CEF with a solid track record.
Best- and Worst-Performing CEF Categories
The most overvalued CEF as of Aug. 3 was also one of the best-performing CEFs in July. After Brexit spooked foreign-equity investors in June, they flooded back into Voya International High Dividend Equity Income (IID), pushing its share price considerably higher than its net asset value. This CEF, the only one in the foreign large-value category, closed the month with a share price gain of 11.85% and a NAV return of 3.31%. Equity precious metals continued to ride the wave of gold euphoria during the month as well.
Overall, July was a good month for most investments, so seeing muni CEFs among the worst-performing categories is not cause for concern. The intermediate-term and long-term muni categories were essentially flat for the month.
Exhibit 6 shows the best- and worst-performing CEF categories ranked by share-price return in July.
Investing in CEFs could seem daunting to investors, but by taking advantage of opportunities like rights offerings and being aware of what a fund's discount or premium really indicates, will lead to better long-term results.
Jason Kephart does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.