CEF Price Risk Is Opportunity; NAV Movements Are The True Measure Of Risk

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Includes: CEFL
by: Alpha Gen Capital

Summary

The price movements of closed-end funds are driven by several factors that may or may not have anything to do with the funds.

The NAV movements can be used to find the factors that are driving the performance of the returns.

Too much emphasis tends to be placed on discounts as opposed to the distribution received on a monthly basis.

John F. Kennedy once stated, incorrectly, that when written, the Chinese word 'crisis' is composed of two characters. One represents danger and the other represents opportunity.

Why Closed-End Funds Are More Volatile

Investors in closed-end funds tend to do two things, buy based on distribution yield while also measuring performance and volatility using market prices. While it is true that market price is what an investor will ultimately pay and receive when buying and selling these securities, we do not think it is the best measure of performance.

The volatility of market prices in CEFs is well-documented and can scare away many investors. What drives that volatility is the structure of the securities, which increases inefficiency. The structural difference between an open-end mutual fund and a closed-end fund is creating some of this added volatility in comparison. Closed-end funds have a fixed number of shares issued and trade amongst investors on an exchange instead of with the fund sponsor.

Added volatility is due to:

  1. Fixed number of shares
  2. less liquid underlying bonds
  3. leverage
  4. low liquidity in shares themselves

This dynamic means that CEFs can deviate away from NAV as opposed to open-end mutual funds, and to a large extent, ETFs. In comparison, a CEF price is largely based on supply and demand and other factors. Sentiment can be one of the largest variables that drives the market price of these securities on a short-term basis. Ultimately, however, the NAV will tend to be an anchor for market price performance.

This security structure does allow for greater flexibility even if the perceived volatility is increased. For one, no capital is flowing into and out of the funds themselves. They are permanent pools of capital whereas an open-end is subject to daily redemptions and inflows. The permanency of capital allows it to invest in less liquid areas of the market and generate higher yields. This can also mean greater volatility as the value of less liquid bonds can be more unpredictable.

Flexibility is also realized through the ability to use leverage. CEFs can borrow up to 50% of assets through both structural and portfolio (derivative) leveraging. Leverage will clearly increase the volatility of the funds, but also enhance rather dramatically the flexibility of the portfolio manager to take advantage of market dislocations, without having to raise cash via the sale of other bonds. Given the low-interest rate environment and these fund sponsors' ability to borrow funds for a fraction of one percent, leverage can be a very prudent means to generate better yields on their bonds.

The lower liquidity of some of the funds, with wider bid-ask spreads, can also add to the volatility of the funds. Many funds are relatively small in total assets and trade only a few thousand shares each day. The limit books can be quite shallow in these funds which can be driven through with one medium-sized market order. Market orders are not advised when trading these funds given that framework.

All of these factors can be combined to exacerbate each other and enhance volatility overall. For example, given the largely retail investor base, the low-liquidity, and the supply and demand of the market, a rush into the funds or particular funds can occur occasionally driving large moves to the up or downside. These imbalances can move the funds much more than the NAV moves on the same day.

Price Versus NAV Standard Deviation

We assessed the entire closed-end fund market. We found 542 active funds (excluding BDCs) and divided them between equity and fixed income. The five- and ten-year standard deviation numbers can be disparate, given the ten-year includes the financial crisis when many funds saw massive moves in both NAV and price.

The five-year NAV standard deviation of fixed income CEF returns is 5.1% (including munis), which compares to the iShares iBoxx $ Investment Grade Corporate Bond ETF's (NYSEARCA:LQD) standard deviation of 5.3% and 6.0% for iShares iBoxx $ High Yield Corporate Bond ETF (NYSEARCA:HYG). In other words, the typical fixed income CEF is less volatile in NAV-terms than two of the more popular fixed-income ETFs. We also compared what top open-end intermediate-term mutual funds had for standard deviations over the last five and ten years.

Equity CEFs have significantly higher volatility numbers, given the use of leverage on already volatile underlying assets (stocks).

Compared to NAV statistics, pricing standard deviations for CEFs are much higher, by roughly 2.5 times. That increased vol is largely due to the dynamics of the industry that we discussed above. The lack of much institutional trading and arbitrage in the space makes the pricing moves much larger on a given basis.

Fixed Income CEFs
Price SD % NAV SD %
5yr 12.5 5.1
10yr 18.9 7.2
Equity CEFs
Price SD % NAV SD %
5yr 20.5 17.6
10yr 30.6 23.0
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Mutual Funds
Name Ticker 5yr SD 10yr SD
Loomis Sayles Bond Fund LSBDX 6.68 9.58
PIMCO Total Return PTTRX 3.64 3.97
Vanguard IntermTm Investment Grade Bond VFICX 3.48 5.09
American Century Diversified Bond ACBPX 2.77 3.19
Oppenheimer Core Bond OPIGX 2.89 9.26
Click to enlarge

Price = Opportunity

Investors typically look at the volatility of CEFs as a significant risk to owning shares. But the excess volatility of the price over the NAV should be looked at in the picture of an opportunity. All else being equal, the market is allowing you to buy the same asset at differing prices. Every once in a while, these assets go "on sale" as the supply and demand imbalance re-prices the funds.

While we think investors focus on discounts and premiums too much - behind only distribution yield - the vol in market prices can offer up an asset that has a true liquidation value below fair value. That fair value is different than the perceived fair value of a stock which does not have a daily NAV. A stock has a perceived value that is based on what an investor is willing to pay. It has no benchmark value to be the foundation of its worth. That supply and demand that drives the price of a stock is the same in the closed-end fund space. However, the price of a closed-end fund will always have a tether to its NAV- its benchmark of value.

For illustrations purposes, we attempted to graph this relationship. The black line in the chart below is the NAV and the blue line is price (pardon the simplicity of the chart). Market gyrations, panics and over-enthusiastic buying can move shares to large premiums or excessive discounts over time.

Click to enlarge

Any day when there's a 1%+ move in CEF can be thought of as a day when there's supply and demand imbalance (outside of ex-dividend days and large moves in interest rates). The NAV of a typical closed-end bond fund moves less than 50 bps even on volatility days - and most days likely less than 20 bps.

Focus On NAV and Income

The second aspect investors need to consider is the stability of the distribution. CEFs pay a monthly cash distribution that is extremely stable month-to-month. For investors seeking a "monthly paycheck" these securities are built for not only generating income but paying it out on a frequent basis. The boards of these funds never want to be in a position of having to cut the distribution, just like the board of a company never wants to have to cut the dividend payout on its company's stock.

An investor in closed-end bond funds shouldn't be overly concerned about pricing volatility if the main objective is current income to meet spending needs. Instead, investors should focus on NAV volatility in order to assess the performance of the portfolio manager, sector and likelihood of a distribution cut. Most investors attempt to market time these funds, and while a relative trade can be productive and profitable from time-to-time, more often than not, it is more constructive to continue to collect the monthly distribution.

In other words, why sell a fund in order to possibly buy it again at a $1.00 less in price so you purchase it at a larger discount, when you receive $0.15 monthly in distributions. If it takes eight months for that discount to materialize, you just wiped out $1.20 in income just to say you bought the shares at a wider discount.

For investors focused on yield and have a long-term time horizon, it shouldn't matter if Mr. Market is pricing your asset at 5% above or 5% below its true value (NAV), as long as you continue to collect you monthly distribution. The volatility on the pricing can then be viewed as a positive allowing the holder to acquire additional shares at opportune times when the supply and demand imbalance favors that action.

Conclusion

The volatility in closed-end funds has to be seen through the correct lens. NAV volatility is the true risk of the underlying assets while pricing risk is really an opportunity for investors. We tend to ignore market prices and analyze the movements of the NAV when assessing closed-end funds. Those movements against factor-based models to examine the correlations that drive the NAV are essential into uncovering the drivers of the fund. Market price volatility tells the investor nothing but does give them the opportunity to buy or sell at anomalous prices.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. As I have no knowledge of individual investor circumstances, goals, and/or portfolio concentration or diversification, readers are expected to complete their own due diligence before purchasing any stocks mentioned. The strategies discussed are strictly for illustrative and educational purposes and should not be construed as a recommendation to purchase or sell, or an offer to sell or a solicitation of an offer to buy any security. There is no guarantee that any strategies discussed will be effective. The information provided is not intended to be a complete analysis of every material fact respecting any strategy. The examples presented do not take into consideration commissions, tax implications or other transactions costs, which may significantly affect the economic consequences of a given strategy. This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding the funds or any security in particular.