By Simon Lack
Certain closed end fund sectors are beginning to reflect expectations of tax changes. Although Congress hasn’t yet decided how to treat the expiring “Bush” tax cuts, consensus appears to be building around maintaining current income tax rates (other than the top rate which is the one that matters to many investors) and modestly increasing taxes on dividends (from 15-20%). National municipal closed end funds, of which there are 104 with a market capitalization of $38BN are trading at a record premium to NAV of 2.4% (according to Morningstar). This sector has only closed the month at a premium six times since 1997 (as far back as Morningstar’s records go). Three of those months were in 2010, and the others were in 1998 (following which they plunged to a record wide discount of 11.5% by the end of 1999).
By contrast, the 14 funds in Morningstar’s Real Estate sector are at an average discount of 14.9%, having widened by 5% since March reflecting refined tax expectations and perhaps nervousness about the sector itself.
What’s fascinating is that changes in the tax code should properly only affect the prices of the underlying securities owned by closed end funds, not the funds themselves. Closed end funds don’t pay tax, so generally changes in the tax code should be fully reflected through NAV movements rather than changes in discounts (although to the extent that a fund has unrealized gains and capital gains tax rates change, the discount to NAV may adjust to reflect that).
We generally think muni CEFs are expensive, whereas we do have hedged long positions in a couple of real estate funds that we think are cheap. One is DWS RREEF World Real Estate (DRP) about which we’ve written before. It’s managed by Deutsche Asset Management and based on their own reports it has been a poor performance (Lipper ranked it 13 out of 19 similar funds last year). Arthur Lipson of Western Investment Management has taken a keen interest and it’s worth following the moves of this activist investor if only to read Mr. Lipson’s periodic and entertaining SEC filings (he recently stated that Deutsche should get out of managing closed end funds entirely). It currently trades at a 14% discount to NAV. We own DRP in the expectation that Deutsche will either find ways to improve its performance or take other steps identified by Western to create value for its stockholders.
Disclosure: Long DRP