The Closed-End Fund Discount Quandary

There are problems with using historical cost accounting, and the move to accounting based on market values seems at first glance to be more accurate. Market values change every day, and so they are not as prone to a particular tendentious bias, especially the hope that a bad asset will rebound in price even though everyone knows it is severely impaired.

Yet, as every critic of this crisis notes, the market is hardly perfect. The same market that priced these same mortgages as if they had basically zero credit risk in 2006 is predicting massive future default rates. If one thinks that the marking to market gives the best assessments, then one can not really say that regulators, or anyone, failed pre 2007. The market suggested no risk, as implied by the market value, or spreads, of these instruments.

Currently, many closed-end funds with market-traded instruments trade at a substantial 20% discount. That is, you can trade their constituents, and they are worth 20% more than the entity that holds them. Above, we see Nuveen's convertible bond portfolio (JPC), and this trades at a 20% discount to the value of its portfolio. Is it wise to therefore value these assets at their net asset value, or the value implied by the closed-end fund?

Further, this is not specific to bond closed end funds, as closed end funds with stocks have similar discounts (see Adams Express, (ADX). Market values, clearly, are not merely unbiased present valuations, because this discount varies over time. If the market has a 20% risk premium assigned to mortgage related products, is it optimal to impute this into book asset valuations?

The bottom line is that if one argues that the market should set book asset values, and thus risk parameters for a solvency exercise, this goes both ways. No one thinks that the market correctly priced mortgage risk in 2006, however, so what does one do?

Comments

[F. Bradeen:]

Eric forgets that the NAV itself is set by, surprise, market price. Market price, although imperfect, is the best method we have to evaluate securities.

Also when my stocks go down and if I am on margin and the market price goes too low. Guess what? I get a margin call. I can jump up and down all I want and say, the market has mispriced my securities but to no avail. Mark to market, like it or not, is the best way we have to evaluate those securities and that especially goes for the junk these banks have on their books.

Mar 16 06:06 PM

[MattZN:]

Closed-end funds are doing a lot more then just holding a basket of securities. Operating at a continuous discount is typically an indication that the fund is doing something wrong.

For example, a fund which has a larger dividend then the dividends being received by the underlying securities might be padding returns with a portion of the original investment. The investor would wind up paying extra taxes on the artificially inflated dividend. The market value of such a fund winds up operating at a permanent discount to its underlying assets.

Many factors are involved when it comes to closed-end mutual funds. Leverage-based risk, past performance, current activities, surprise, large fund inflows or outflows which effect performance, and so on and so forth. The investor has no ability to drill down and arbitrage the individual securities making up an actively managed fund.

Thus, the market value of the fund can still be correct even when it differs from the market value of the securities making up the fund. Funds which trade at substantial discounts are a huge red flag for me. Of course, I don't invest in mutual funds any more at all, they have for the most part proven themselves unworthy of my attention so why would I want to pay the fund upwards of 1% plus other fees when I can just own the underlying stocks instead? Ok, bonds ARE a somewhat different animal, there are still good reasons to own bond funds. Even so, I find myself unwilling to give fund managers those fees these days.

-Matt

Mar 16 08:07 PM

[petes:]

a little confused with what you're getting at here.

the price of closed end funds depends on not only its net asset value, but also the quality of its management and management fees. though less extreme, valuing a CEF at its NAV is, in concept, no different than valuing a publicly traded company at its book value.

so to answer your question, "Is it wise to therefore value these assets at their net asset value, or the value implied by the closed-end fund?": of course they should be valued at the traded price of the CEF.

Mar 16 08:15 PM

[The Little ...:]

The fact that a closed end fund sells at a large discount to its net asset value does not mean that it is a bad fund. Some times very large discounts present wonderful buying opportunites. There are a number of reasons why closed end funds trade at prices different from net asset value. First we are talking about different markets. The market for the fund's stock is not the same as the market for its individual assets. Different dynamics, especially in the short run affect the different markets. Emotions and short selling and covering also come into play. At any time closed end funds can narrow or eliminate the discount by buying back their own shares or by converting to an opened end or exchange traded fund.

Mar 16 09:34 PM

[jeff m110:]

Nuveen has a site, with info on closed ends, from many companies. They mention that some closed end funds use leverage. by selling preffered shares or auction rate securities they leverage up. Not all, but many of them. I think the chronic discounts may be because of this. The nuveen site is handy for this info, which might otherwise have to be gleaned from prospetus's.

www.etfconnect.com/sel...

Mar 16 11:59 PM

[donzelion:]

I like Nuveen's etfconnect.com as well. I've found that CEFs often charge unusually high fees - often 2-8x greater than a comparable ETF. Meanwhile, the payout from leverage and other sources is often 2-3x higher than a comparable ETF. Originally, I'd thought that a 10% yield with 3% fees = 7% total gain (assuming a completely flat market) v. ETFs, where several offered a 5% yield while charging .5% fees or less = 4.5% total gain (also assuming completely flat market).

I've since rejected that original theory after a bit more research (and dumped the CEFs I'd purchased). Long-term, 10-20 years, most CEFs have gradually declined, which suggests they were paying out principal along with leverage. If so, then a "discount" would merely reflect degrading principal over time (once you apply leverage, the NAV remains the same on paper, but in practice, is quite distinct). If so, then over time, high yield CEF's serves merely to "launder" principal into yield (while enriching a manager) - why would I want to do that?

Mar 17 04:05 AM

[biomedlives:]

I believe that, when a CEF pays dividends that are higher than its income, the year end tax statement identifies as a return of capital the amount that exceeds income.


On Mar 16 08:07 PM MattZN wrote:

> Closed-end funds are doing a lot more then just holding a basket
> of securities. Operating at a continuous discount is typically an
> indication that the fund is doing something wrong.
>
> For example, a fund which has a larger dividend then the dividends
> being received by the underlying securities might be padding returns
> with a portion of the original investment. The investor would wind
> up paying extra taxes on the artificially inflated dividend. The
> market value of such a fund winds up operating at a permanent discount
> to its underlying assets.
>
> Many factors are involved when it comes to closed-end mutual funds.
> Leverage-based risk, past performance, current activities, surprise,
> large fund inflows or outflows which effect performance, and so on
> and so forth. The investor has no ability to drill down and arbitrage
> the individual securities making up an actively managed fund.
>
> Thus, the market value of the fund can still be correct even when
> it differs from the market value of the securities making up the
> fund. Funds which trade at substantial discounts are a huge red
> flag for me. Of course, I don't invest in mutual funds any more
> at all, they have for the most part proven themselves unworthy of
> my attention so why would I want to pay the fund upwards of 1% plus
> other fees when I can just own the underlying stocks instead? Ok,
> bonds ARE a somewhat different animal, there are still good reasons
> to own bond funds. Even so, I find myself unwilling to give fund
> managers those fees these days.
>
> -Matt

Mar 17 09:55 AM

[oldman:]

I only prefer muni closed end funds. There is poor transparency for equity closed end funds and many who invest in them do not understand them. Avoid them is just my opinion.

Mar 17 10:55 AM

[staria:]

I'm a portfolio manager in a mutual fund company and we have a lot of open end funds. The problem since last fall is, then when the market doesn't function and you have redemptions.... you can sell only your best ....and most liquid assets..... The closed end funds doesn't have this problem.... and this is a huge advantage in today crazy world. With discounts to NAV.... a huge investment opportunity, one in a lifetime.

Mar 17 03:59 PM

[d_teller:]

The NAV of CEF holdings can be 3-6 mos. out of date. in a falling market, such as late last year through Feb of this year, the NAV discounted by market pricing was a markets realistic analysis of a downward valuation (in the present) of the past , listed holdings...Funds that held GE, or other seemingly AAA - rated investment grade securities, appeared to have a bigger discount than those that seemed to have A-rated U.S. Treasuries, which simultaneously had a market premium in price vs their holdings values.

Mar 17 11:03 PM

[JeffG.:]

You have to read the quarterlies of the CEFs very carefully and look at the UNII line. If the UNII is positive, that means the payout is honest, i.e., they are not paying out a return of capital instead of income. If the UNII is negative, this could result in the fund habitually trading at a discount to NAV.

The Nuveen family is pretty good at adjusting the monthly/quarterly payouts so they are consistent with income. This maintains the NAV, and in a good market, the NAV goes up and so does the security (and the payout could also go up by the way if the average coupon % rises).

I trade CEFs all the time, and obviously search for severe discounts to NAV, subject to the above. Some of the smaller CEF outfits - Cohen and Steers comes to mind - have a "managed return" philosophy, which I find troublesome. Too much "smoothing" of results for my taste. That's probably why some of their CEFs - look at INB and RQI - trade a severe discounts to NAV.

The Barclays iShares are really the best overall for liquidity and honesty. LQD and HYG are really good for income if you are interested in that. They trade so much that the market eliminates any value anomalies - you get what you pay for.

Mar 18 08:51 AM

[ZZ:]

If a CEF is selling at $4 which a 20% discount to NAV of $5 and paying a 20% dividend of the NAV, and all of it is Return of Capital, then the discount is forced to shrink. In 5 years almost all of the NAV will have been paid out and the owner will have been paid out what he put in (the $4 market price) plus much of the $1 discount.

Mar 20 12:07 PM

[sskell:]

ZZ - agree; I love CEFs that trade at a steep discount and overpay distributions. Too many CEF investors are dividend focused, not total return focused.
d-teller: your thesis is incorrect; CEFs value their holdings nightly through exchange or third party services
oldman: pricing transparency is many times GREATER for equity CEFs than muni CEFs; you've got this backwards

Like staria, I manage(d) both open end and closed end funds. This board should listen to him; this is great buying opportunity given the size of the discounts in the CEF market. The real drivers of these discounts are retail sentiment (negative); dividend trends (negative), market direction (negative) and market volatility (negative), IMHO.
Take a look at NFJ: like many CEFs, it was overdistributing. When the manager reduced the dividend to rectify that, the fund discount to NAV increased 10% to about 25%! This fund has a 97% correlation to the S&P500; it's very large ($2b); its fees are reasonable (96bps)and its dividend is reflective of actual market conditions. It's historical discount pre-2008 was around 3-5% (my eyeballing of the charts). So why would you own SPDRs when you can own the same thing at a 25% discount?

Mar 22 09:58 AM

[CEFspert:]

Why compare CEFs to ETFs?!!
They should be compared to Open Ended Mutual fund fees.. not ETFs.
They are mindless indexes.. but picked securities of a group.. not all of them.

The Yearly Fees of CEFs are no different, and probably a Bit less than Open ended funds. And never any load.
So by and large they are a less expensive vehicle that can be bought a substantial discount.. and usually pay a higher dividend.

Ironically, and fortuitously if you nknow what you're doing, the discount is often highest when the market is lowest-- making a Double Cheap Vehicle.

This does NOT reflect management... this reflects market conditions.

In November MANY CEFs traded over a 30% Discount. This had Not to do with managment of even whats in the portfolio.. which as someone said is already Marked to Market.

ATypically, one tries to buy a Good CEF at 10-15% Disct and sell it at 5% and below disct- even a premium.

In the last year.. it's more like buy at 21-25% disct and sell at 15% disct.

I bought a whole Pile of Muni CEFs in December for 20-28% Discounts.
Out of most but still hold a few long term.

So when the author talks about JPC. at a 20% disct and reading something into mgt or portfolio.. his 'quandary' is his knowledge..
One can still buy some decent Muni CEFs at 15% Disct.

This week ZTR (Zweig Total Return) which is 1/3 'Cash (Short Trea notes), 1/3 Medium Treas Bonds, and 1/3 Blue Chips, (CVX, MO, etc).. was trading at 18% disct and has done so routinely.
Now it's 16% disct.

Does the author think this is a function of the Great 'Risk' of management?




On Mar 17 04:05 AM donzelion wrote:

> I like Nuveen's etfconnect.com as well. I've found that CEFs often
> charge unusually high fees - often 2-8x greater than a comparable
> ETF. Meanwhile, the payout from leverage and other sources is often
> 2-3x higher than a comparable ETF. Originally, I'd thought that a
> 10% yield with 3% fees = 7% total gain (assuming a completely flat
> market) v. ETFs, where several offered a 5% yield while charging
> .5% fees or less = 4.5% total gain (also assuming completely flat
> market).
>
> I've since rejected that original theory after a bit more research
> (and dumped the CEFs I'd purchased). Long-term, 10-20 years, most
> CEFs have gradually declined, which suggests they were paying out
> principal along with leverage. If so, then a "discount" would merely
> reflect degrading principal over time (once you apply leverage, the
> NAV remains the same on paper, but in practice, is quite distinct).
> If so, then over time, high yield CEF's serves merely to "launder"
> principal into yield (while enriching a manager) - why would I want
> to do that?

Mar 26 05:42 PM