Closed-End Fund Discounts as a Predictive Investment Tool

Conclusion: In addition to CEF investors utilizing absolute discounts to net asset value [NAV] as a selection criterion, they should also consider the trend of such discounts in selecting both entry and exit points to maximize investment returns. Based upon the analysis of ASA Limited (ASA), it appears an investor buying ASA at discounts greater than its historical average should continue to buy the shares if the discount continues to widen. Once the extended trend of greater discounts has ended by a sustained decrease in the discounts, the investor should sell all of his/her accumulated holdings on the average of 6 to 12 months subsequent from the trend reversal.

CEF Discounts as an Investment Criterion: Most CEF investors will point to closed-end funds [CEF] trading at a discount as an important investment selection criterion. The thinking is CEF shares that trade at a wide discount from their historical average will gravitate towards that average over time. As a consequence of this central tendency, the future share price movement would likely result in capital appreciation. This seems intuitive. It’s consistent with buying a dollar for some number of pennies less than 100 and redeeming the dollar later for 100 pennies and pocketing the difference. The less pennies used to buy the dollar the more attractive the investment return. The chart for ASA below supports that notion: the greater the discount the greater the 12 month future price change—and vice versa.

click to enlarge

Relationship between Discount vs. Future Annual Price Changes: Based upon the month-end share price and premium/discount (PremDisc) of ASA Limited, there appears to be a visible relationship between its PremDisc and its price change 12 months forward. (Note: I used the inverted 12 month forward price change for easier graphic display. In reality, the greater the discount the greater the forward 12 month price change and vice versa).

What is interesting, as depicted in the accompanying chart, is the directional trend of the PremDisc and the future price appreciation 12 months forward. They seem to track during extended periods of sustained upward or downward movements. Therefore, in addition to the absolute PremDisc relative to its historical average being an investment selection factor, the trend seems equally important. If the premise is correct, then the 12 month future price change for ASA is likely to be flat to down—as the recent 3 month moving average for its PremDisc appears to be “rolling over.”

An Investment Edge: The actual statistical correlation between PremDisc and 12 month forward price change for ASA is fairly modest. (For you propeller heads, r^2=17). Essentially, PremDisc as the sole and accurate predictor of future price change appears weak and is only one of several factors. While statistically one may not be able to predict with pinpoint accuracy the future annual returns based upon the level of PremDisc for ASA, one can see from the chart there appears to be a perceptible relationship between the two. In the investment business, all you need is a slight edge versus your competitors to generate alpha.

ASA Post Discount Trend Cycle Returns: An investor buying ASA at discounts greater than its historical average should continue to buy the shares if the discount continues to widen. Once the extended trend of greater discounts has ended by a sustained decrease in the discounts, the investor should sell all of his/her accumulated holdings on the average of 6 to 12 months subsequent from that trend reversal. The accompanying table reflects ASA’s downward discount cycles and the returns generated by the strategy. By comparison the historical average 12 month price change for ASA since inception has been 5.9%.

Caveats: The conceptual value of the PremDisc as a predictor of future share price performance is contingent on accurate pricing of the underlying assets [NAV] and the underlying trend of the asset price. It may be that a widening share price discount to NAV is a function of the NAV being mispriced (shallow markets) or a secular re-pricing of the asset class (ex. sub-prime mortgages). The CEF share price may be correctly responding to the future asset price changes and its movement does not represent a deviation from the mean. Additionally, whether one can extrapolate from the relationship of ASA to other CEFs is a topic of further inquiry. Lastly, the CEF industry is experiencing unusual stresses from the freezing of the Auction Rate Preferred markets and their recapitalization to regulatory restraints on distribution to common shareholders that may render historical observations ineffective—at least in the near-term.

Disclosure: Author owns ASA.

Comments

[nym:]

Thanks, I hope to see you analyze other ETFs for diversification. Should I put you on my watch list?

2008 Dec 08 10:39 AM

[Urbane Gori...:]

Nice topic and clearly presented... Buying an historically cheap NAV is a common model.

For those that dollar average into ETFs, stocks and funds, they may want to stick their cash in a checking account and wait for a day when the market is just ugly. Then hold your nose and buy. The inverse is true for selling. Pick an exuberant day to sell your fund. This is particularly true in a market that can move 1000 points in one day, and funds can swing 8% that day. You may be giving yourself or reaping a 10% bonus.

jegan

2008 Dec 08 04:24 PM

[Joe Eqcome:]

nym, I'm interested in pursuing the arbitrage possibilities between similar type ETFs and CEFs. I don't know if that's of interest to you.
Happy Holidays!
Joe Eqcome


On Dec 08 10:39 AM nym wrote:

> Thanks, I hope to see you analyze other ETFs for diversification.
> Should I put you on my watch list?

2008 Dec 09 11:57 AM

[Joe Eqcome:]

Jegan,
I fully subscribe to your strategy.
My incremental value might only be for buying on subsequent days of nausea.
Happy Holidays!
Joe Eqcome



On Dec 08 04:24 PM jegan ;-) wrote:

> Nice topic and clearly presented... Buying an historically cheap
> NAV is a common model.
>
> For those that dollar average into ETFs, stocks and funds, they may
> want to stick their cash in a checking account and wait for a day
> when the market is just ugly. Then hold your nose and buy. The inverse
> is true for selling. Pick an exuberant day to sell your fund. This
> is particularly true in a market that can move 1000 points in one
> day, and funds can swing 8% that day. You may be giving yourself
> or reaping a 10% bonus.
>
> jegan

2008 Dec 09 12:05 PM