When I started investing in closed end funds five years ago it began as a way of capturing aggressive exposure to the fixed income markets, but over the years has transformed into a complete income and alpha generation strategy. I discovered early on the use of leverage could work to my advantage, especially in a retirement account at a relatively young age, since I was purely interested in total return and not spendable income. I found that I could use volatility to my benefit to enter positions, and get equity-like returns as well as higher dividends that could be reinvested at no additional cost. I also realized that I could get access to the most talented managers as well as their "best and boldest ideas" to generate superior returns even over similar open-end mutual funds that were geared towards the typical retail investor. The only difficult and seemingly arduous task was evaluating when to buy, how much to buy, and most importantly, when to sell.
The backbone of any closed end fund strategy is monitoring the fund's price vs. NAV. There is no simple rule of thumb since CEFs can trade at discounts or premiums for their entire life depending on a multitude of factors including management team, strategy, leverage ratio, asset class, corporate actions, expenses, yield, size, retail or institutional investor interest.
So the task at hand comes down to formulating a strategy in which to weight the factors above to figure out how much you are willing to pay for a particular fund in relation to its NAV. I will delve into a few of my favorite examples later in the series, but one of the most glaring instances of retail investor interest in a CEF was last year's run up in the PIMCO High Income Fund (PHK), managed by Bill Gross. This fund traded as high as a 77.46% premium to its NAV, due in large part to its very high distribution rate of 16.5%, of which it consistently under-earns and relies on capital appreciation to compensate for the return of capital to its shareholders. After Barron's brought this inefficiency to light for many investors, PHK's premium traded down to just 22%, which I still wouldn't have paid, even with Bill Gross behind the wheel. This is a prime example of why this type of due diligence can go a long way when shopping for income or capital appreciation potential in CEFs for your portfolio.
My own personal selection profile includes funds managed by well respected teams trading near their NAVs, or at modest premiums and that offer an alpha seeking strategy that I can't reasonably recreate myself using low cost ETFs. I also tend to favor funds that have a positive UNII, or undistributed net investment income, meaning their portfolio generates more cash flow than what the board has elected to distribute to shareholders. Another critical consideration is the fund's use of leverage, since the leverage ratio will both amplify positive and negative returns. I lean towards funds that employ a responsible amount of leverage that is borrowed at very attractive rates, making for a more meaningful spread from the cost of borrowing and potential return of the CEF's portfolio. The factors that don't weigh particularly high in my decision making process are a fund's size, or yield, since I care more about the fund's chances for strong NAV performance and total return over the long term.
Now that you have narrowed the field and created a short list of funds you want to own by applying your own weighting to the factors surrounding a CEF, developing a trading strategy should come next. Entering and exiting CEFs can be tricky, mainly because of liquidity, so be mindful of the average daily volume of your funds; that way you know what a reasonable number of shares you can move in a single day is. I always set a target on how large I want my position to ultimately be, then break it into 4-6 purchases or sales; that way you are spreading your risk over time.
My trading strategy usually involves initiating a small market order to get a starter position established, then limit orders to build out the position to my target size at the prices I designate. I seek to make purchases below the trailing 52 week average premium or discount, and sales above it, so that you're using this inherent feature of CEFs to your advantage, and not selling during times of distress or buying during times of euphoria - since they both seem to happen often in the CEF marketplace.
New Closed End Funds
New CEFs go through an IPO process in which, like any other stock, shares are offered to investors before trading begins in the secondary market. I never buy into the hype of a new closed end fund until I'm able to evaluate the strategy in detail as to warrant if the initial IPO premium is worth the hefty price tag. Almost all IPO participants pay a "load" to the new fund's sponsor, which can be as high as 5%, so a new CEF that IPOs at $25 a share would have a $23.75 NAV right out of the gate. An example of a fund I actually paid the IPO premium for is the DoubleLine Opportunistic Credit Fund (DBL) when it was first launched. I was able to ascertain the strategy was a more aggressive version of Jeffrey Gundlach's extremely successful total return strategy. Therefore I felt comfortable purchasing a starter position on the day it IPOed, especially since I knew it wasn't going to employ leverage right off the bat. An example of a fund that I waited on is the recently launched PIMCO Dynamic Credit Fund (PCI). I was not able to get a clear vision in my mind of what areas of the fixed income market the fund would be targeting, in addition to what the fund's duration, credit quality, or strategy might be. After the fund burned through its IPO premium from poor price performance and strong NAV performance, I decided to initiate a position very near to par. To this day I believe this fund presents a great opportunity for new investors because it continues to show strong NAV performance in addition to trading at a modest discount. PIMCO should also be posting their schedule of holdings by the end of May since the fund will have a full three months of operating history. This should allow me to cement my belief that the fund's strategy will play an integral role in the future of my CEF portfolio.
Like any investment strategy, developing a plan and implementing it decisively will ultimately produce excellent results. Now that I've laid the ground work for my baseline criteria for selecting a CEF, in Part 2 of this series of articles, I will discuss in greater detail varying degrees of attractiveness of the factors contributing to owning a CEF, as well as positions I currently own and would like to own in the future at more attractive prices, and why.
Additional disclosure: Fabian Capital Management, and/or its clients may hold positions in the ETFs or mutual funds mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities.