Laws of Closed-End Fund Investing Suspended?

The performance of the closed-end fund (“CEF’) sector YTD has once again confirmed that investing is more of an art than a science. The investment tenets that:

1. dividend yield provides a downside cushion for a stock price;
2. buying assets pennies on the dollar makes for an attractive investment;
3. lower volatility (beta) would cause a stock to fluctuate less than a higher beta stock haven’t seemed to work for CEFs this calendar year.

CEFs have significantly underperformed the equity markets as measured by the S&P 500 in a fashion contrary to investment expectations. Employing the SPDR S&P Depositary Receipt ETF (SPY) as a proxy for the equity market, SPY YTD is down approximately -20% versus -37% for the CEF sector. That performance is in spite of CEFs’ lower beta relative to the S&P 500 (approximately 75% of the S&P 500). The average dividend yield for the CEF sector is almost 12% versus 2.4% for SPY. Most astonishing is the share price discount to NAV for the CEF sector is -14.5% versus a discount of -0.27 for SPY.

Three reasons most cited for this year’s poor CEF performance are:

1. auction rate preferred shares debacle earlier in the year impacting CEFs' leverage;
2. CEF regulatory leverage limitations impacted by significant asset valuation declines;
3. retail investors, the bulk of CEF investors, tendency to sell at the bottom and buy at the top.

Below is a chart that illustrates the positive correlation between CEF discounts and changes year end in the S&P 500, i.e. as the S&P 500 increases, CEF discounts contract, and vice versa.

click to enlarge images

As Mark Twain remarked, “History may not repeat itself, but it sure rhymes.” Consequently, if equity markets recover, CEFs could show incremental returns over equity market performance as CEFs’ discounts narrow.

CEFs Poised to Benefit: The category that has suffered the most YTD has been world equity funds, down 57.3%. It would be logical to assume that this group may outperform other CEF peer groups in an equity market recovery. (In fact, this sector has shown strength in recent market rallies.)

The following CEFs are general world equity market plays—and not nation specific—that may benefit from a recovery in the stock market. (Mean Deviation is calculated by subtracting the current discount from its average historic discount.)

Disclosures: The author owns APF & LAQ

Comments

[Joe Eqcome:]

Erratum: Distribution yield for LAQ should be 0.11% vs 11.0% due to a misplaced decimal point and LAQ's discount should be a negative number -10.3% vs 10.3% in the final chart. Sorry for the inconvenience.

2008 Oct 29 08:56 AM

[bsharvy:]

Where do you find the average discount to NAV, as mentioned here: "the share price discount to NAV for the CEF sector is -14.5%"?

2008 Oct 29 10:01 AM

[Do not own BRK:]

Go to cefa.com - for discount and CEF info.

2008 Oct 29 11:41 AM

[searcher:]

Is there a source that compares these CEF's using a metric for their use leverage?

2008 Oct 29 01:56 PM

[Joe Eqcome:]

Searcher,

Go to ETFconnect.com find a fund. URL is below and It will allow you to compare funds side by side. I think you'll find it an extremely useful tool.
www.etfconnect.com/sel...

Best,
Joe Eqcome

2008 Oct 30 09:08 PM

[bsharvy:]

I don't see info at that site that gives the average discount for all closed-end funds.


On Oct 29 11:41 AM Cefa wrote:

> Go to cefa.com - for discount and CEF info.

2008 Nov 07 06:52 PM

[Chris Schons:]

At today's close, LAQ's share price was trading at a 17.3% discount to its NAV.

Why? And, should we expect this gap to close as 2009 progresses? Also, does it have something to do with an impending capital gains distribution?

(I have owned LAQ for years now, and obviously I want the discount to NAV to disappear; why not break up the CEF and sell its constituent parts otherwise?!!)

Thank you.

2008 Dec 09 11:18 PM