CEFs Can Be a Measurement of Retail Investment Risk Assesment

Conclusion: An index of a three month moving average of the difference between the percentage changes in closed end fund (CEF) prices versus net asset values (NAV) may be a good indicator of retail investors’ assessment of investment risk (CEFSprd); it inversely tracks the institutionally dominated VIX Volatility Index. The VIX is widely regarded as the stock market’s “investor fear gauge” (see chart below). The CEFSprd indicator suggests retail investors are just as savvy as institutional but are less volatile.

click to enlarge

Investment Implications: The dramatic change in the CEFSprd Index might signal a shift to more risky segments of the CEF market. A screen of CEFs with both high beta and relative strength produced a handful of world equity funds. The top 3 include: Chile Fund (CH), Taiwan Fund (TWN) and Morgan Stanley Asia-Pacific Fund (APF) (see table below). If the stock market continues to increase in the wake of the passage of a “Stimulus Plan” these stocks should benefit, if not they’re likely to suffer.

Summary: The CEF market segment is dominated by retail investors. This is a result of the high dividend yields that appeal to retail investors and the small market capitalizations that make CEFs less appealing to institutional investors. As a result, the behavior of CEF stock metrics might provide a window into the risk assessment of retail investors.

Assumptions: In theory, a CEF’s share price should trade close to its NAV. A calculation of the difference (spread) between the monthly percentage change in share price and the monthly percentage change in the NAV would indicate investors’ sentiment regarding CEFs’ investment risk. A CEF’s share price that results in a negative spread relative to its NAV would indicate a perceived risk that the share price may not reflect the underlying value as expressed by the NAV. In a declining stock market, investors may sell CEF shares indiscriminately, not taking into consideration their underlying value. The increased negative spread would be an indication of increased risk or “fear” by CEF investors. (To a large extent this is captured by the premium/discount calculation; however, the CEFSprd is a better index for computational consistency when compared to the VIX.)

Observations: The chart above illustrates the comparison of a 3 month moving average of the inverted CEFSprd Index (CEFs’ monthly difference between price change and NAV change) and a 3 month moving average of the of the VIX’s percentage change. The VIX is known as the “investor fear gauge” as it is a measurement of the implied volatility based upon option premiums on the S&P 500. It is heavily used by institutional investors as both a trading vehicle and as a hedging mechanism for large portfolios. (There is an inverse relationship between the VIX and the S&P 500. As investor fears rise, i.e. VIX increases, the S&P declines.) The period of comparison is from the previous stock market trough of Oct ’02.

If the VIX is considered a good gauge of institutional investors’ risk assessment and CEFSprd considered a reasonable risk assessment for retail investors, then retail investors are as savvy as institutional investors in assessing investment risk but do so with less volatility. One observation is the VIX turned down months prior to the CEFSprd at the most recent cycle top Oct ‘07.

CEF Screen: The CEF universe was screened (priced Feb 6th) for high beta stocks with better than 50% relative strength, no auction preferred stock, greater than $100 million in assets and trading at a discount. These are highly risky stocks that would suffer if the market were to decline. (Consult your financial advisors prior to any making investment.)

Disclosure: Joe Eqcome owns TWN, CH & APF

Comments

[mavericks:]

Finally, someone picking up on the fact that CEF's have exploded to the upside since the Nov. lows, although I don't think this is all retail investors. Hopefully, CEF's are the canary in the coal mine and the market is due for a rally. If not, CEF's are in a BUBBLE because many I follow have gone from deep discounts to premiums.

Feb 10 09:25 AM