A Cautious Approach To Closed End Funds: Commodity Exposure At A Discount

Includes: BPT, CFD, GLD, PHK, SLV
by: ValueArtifex

Closed end funds are often inherently risky propositions, especially when they are first offered on the public markets. Seth Klarman's famous (though unfortunately now out of print) work, "Margin of Safety," includes a very insightful discussion of the dangers posed by closed end funds acquired by an individual investor at a premium and the possibility of opportunities to be had when the funds decline considerably in price until the underlying assets are offered at a discount.

The Importance of Buying at a Discount

When purchasing any closed end fund, I look to buy my shares at a discount to the assets in the portfolio. If there is a dollar in the fund, I'm only interested if I can pay less. I recently acquired some shares in the Nuveen Diversified Commodity Fund (NYSEMKT:CFD) a little below $20, against a current NAV of $21.55. The fund holds a diversified basket of commodities and forward futures contracts. Energy, agricultural commodities, metals, are all represented. The fund currently sports an annual yield of 8.4% which is distributed to shareholders in monthly increments.

I based my purchase decision on the three following factors

1. The presence of a discount to NAV: First and foremost, this is the most important consideration in my mind to have when one is purchasing any type of Closed End Fund. The fund is also actively managed by an experienced group of professionals and consequently their skills and labor also are also offered at a discount.

2. Demand for Yield in a Low-Rate Environment: I believe that there is a considerable demand for any type of high yielding asset. This often has led to a dramatic overvaluation of high yield CEF's and Royalty Trusts relative to their NAV's or the performance of their underlying assets. As money floods into these funds in search of yield, the premium to the underlying assets increases considerably as a function of market demand. For late buyers, there is a considerable risk in the likelihood of a collapse wiping out nearly a year or more of distributions -- an outcome that is potentially devastating for unsuspecting income oriented investors. If you are investing for income, risking a considerable loss of principal for a few points more annually is unacceptable in my mind.

Two notable examples that readily come to mind from 2012 were PIMCO High Income Fund (NYSE:PHK) and BP Prudhoe Bay Royalty Trust (NYSE:BPT), both suffered large declines and serve as telling examples of the hazards of paying high premiums or retaining unrealistic expectations about the futures of CEF's and Royalty Trusts (another vehicle that promises high yields, yet often comes with hidden risks). I believe that if an investor can purchase a high yielding vehicle at a discount, there is a significant possibility for appreciation in this current environment due to the widespread demand for yield among the investing public, regardless of the nature of the underlying asset. Despite this theory, I am also keenly aware of the speculative dimension of this belief.

3. Diversification and Inflation Protection: Prior to my acquisition of CFD, my portfolio lacked any form of commodity exposure. Though I am a proponent of diversification, I believe it is difficult, risky and costly from a transactional perspective for an individual to acquire numerous singular commodity ETF options such as SPDR Gold Trust (NYSEARCA:GLD) or iShares Silver Trust (NYSEARCA:SLV). Instead, I felt that buying a fund that offered a basket of commodities, with a robust yield and trading a discount would give me the type of exposure to everything I wanted. Jessie Livermore's discussion of commodities also rang especially true for me: "It's like the track. A man may beat a horse race, but he cannot beat horse racing." The only thing to do is to bet on horse racing.

Uncertainty about the status of the U.S dollar was also a significant motivation for me to seek exposure to commodities through this vehicle as a hedge against unexpected currency weakness.

In contrast to other types of assets, the NAV of CFD's holdings are more subject to volatility by virtue of exposure to commodities markets, and an individual investor should be aware of such a fact. Despite these risks, I believe it makes sense to acquire shares in CFD when market behavior produces a discrepancy between NAV and price for anyone seeking to add commodity exposure to compliment their portfolio's holdings. The robust yield doesn't hurt either.

Disclosure: I am long CFD. 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.

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