The Indiscriminate Buying Warning For Closed-End Fund Investors: CEF Weekly Update

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Includes: ADX, BIF, CLM, CRF, DMO, DNI, ECC, GAM, GGZ, GUT, ISL, PCK, PCQ, PEO, PGP, PHK, PZC, RCS, RGT, RIF, SRF, USA
by: Michael Foster Financial Services

Summary

Indiscriminate buying of funds for the wrong reasons is causing irrational price changes that don't match NAV performance or relative fund quality.

While some funds are showing more efficient price action, their low liquidity indicates a risk that investors need to consider.

Many opportunities to get outsized returns with CEFs remain, but identifying them is getting harder.

One of the biggest trends in early 2017 was the "rediscovery" of closed-end funds. Thanks in large part to the market's fundamental misunderstanding of how rising interest rates impact bond funds, and the market's lumping together of equity CEFs with bond CEFs, we have seen a multi-year tear away from CEFs that caused too many opportunities for the market to ignore any further. As a result, discounts began to shrink significantly across the board.

Since this summer, we have seen a somewhat different trend that I suspect may dominate the second half of 2017: growing demand for CEFs and indiscriminate purchasing will cause outsized discrepancies between NAV and price performance. Fund flows have already begun to significantly influence which funds are most discounted and most premium priced regardless of underlying NAV performance. While in the past this was largely a result of yield appetite, increasingly going forward this may likely be due to brand recognition, false associations between dissimilar funds, and the extreme sensitivity of small funds.

Biggest Discounts

We continue to see familiar names in the top ten most discount CEFs. Both the Boulder Growth & Income Fund (NYSE:BIF) and Dividend & Income Fund (NYSE:DNI) remain the two most discounted funds, although now BIF is slightly more discounted than DNI after the REIT fund had kept the least coveted spot in the CEF universe for several weeks:

Symbol

Management Fee + Interest Expense

NAV

Price

%Premium/Discount

%Yield on Price

BIF

1.43%

11.58

9.55

-17.53

4.3

DNI

1.69%

14.96

12.38

-17.25

4.85

RMR Real Estate Income Fund (RIF)

2.24%

26

21.83

-16.04

6.05

General American Investors (GAM)

1.24%

40.54

34.13

-15.81

0.85

Adams Diversified Equity Fund, Inc. (ADX)

0.62%

17

14.36

-15.53

0.35

Royce Global Value Trust, Inc. (RGT)

1.71%

11.11

9.46

-14.85

1.48

Cushing Royalty & Income Fund (SRF)

4.02%

9.35

8.08

-13.58

5.94

Liberty All-Star Equity Fund (USA)

1.08%

6.54

5.66

-13.46

9.19

Gabelli Global Small and Mid-Cap Value fund (GGZ)

1.63%

14.19

12.31

-13.25

0.41

Adams Natural Resources Fund (PEO)

0.79%

21.36

18.53

-13.25

0.54

Two significant changes have appeared this week, with Aberdeen Israel Fund (NYSEMKT:ISL) falling off the top 10 list thanks to a 2.2% price gain in the last week. At the same time, ISL's NAV fell slightly (less than 1%), again indicating that fund flows instead of a recent performance change can have a significant impact on CEF pricing and performance. With a $77.1 million market cap and average daily volume of less than 4,000 shares (worth about $75,000), it's easy to see how small moves can have a big impact on certain CEFs. This is both a significant risk and a significant opportunity that many investors, especially income-focused investors, need to be aware of when analyzing closed-end funds for their portfolios.

Biggest Premiums

Yet again Pimco is the leading issuer of high-premium CEFs, again demonstrating investors' awe of this institutional investor's past performance and investment acumen. Again, the PIMCO Global StocksPLUS&Income Fund (NYSE:PGP) remains far above its sibling funds from Pimco with a 60.5% premium that is about 20 basis points lower than last week. Meanwhile the PIMCO Strategic Income Fund (NYSE:RCS) saw its premium rise 390 basis points in a week due to a 2.92% price gain while its NAV was mostly flat:

Symbol

Management Fee + Interest Expense

NAV

Price

%Premium/Discount

%Yield on Price

PGP

2.75%

11.11

17.83

60.49

9.87

RCS

1.28%

7.76

10.21

31.57

8.46

PIMCO High Income Fund (PHK)

1.08%

6.8

8.72

28.24

11.11

PIMCO California Municipal Income Fund III (PZC)

1.33%

9.93

12.69

27.79

5.67

Gabelli Utility Trust (GUT)

1.67%

5.51

6.93

25.77

8.66

Western Asset Mortgage Defined Opportunity Fund (DMO)

2.58%

21.61

26.55

22.86

10.62

PIMCO California Municipal Income Fund (PCQ)

1.29%

14.28

17.1

19.75

5.4

Eagle Point Credit Company Inc. (ECC)

10.05%

17.71

20.82

17.56

11.53

Pimco California Municipal Income Fund II (PCK)

1.38%

8.71

10.19

16.99

5.57

Cornerstone Total Return Fund (CRF)

1.45%

12.84

14.95

16.43

18.37

As with ISL, RCS became more expensive over the week not because of any dramatic change in performance but merely as a result of fund flows; due to higher demand from investors for this particular fund, the price went up significantly despite its NAV not budging.

This isn't just a one-week phenomenon. Over the last year, RCS's price has increased 6.4% while its NAV has declined 1.15%. This means investors are paying more for RCS's performance (which has not been very good over the past year). While this is common to high-yield funds with unsustainable dividends, this also occasionally happens with lower-yielding funds with somewhat more sustainable dividends (in the CEF world, 8.46% is not a very high yield).

However, we should also note that ISL's NAV and price performance over the last year are much similar, at 15.03% and 14.11%, respectively. Note also that ISL's discount has actually risen in recent months to almost its 52-week high. This indicates that, while ISL isn't as good of a buy as it was a week ago, it is a better buy than it was throughout much of 2016, although both then and now the significant risks of investing heavily in a low-volume small fund remain a concern.

Average Premiums and Discounts

The Closed-end Fund Association publishes weekly averages for the premiums/discounts of both bond and equity funds. While this data is slightly delayed, it is nonetheless a very helpful barometer for overall demand in the CEF market and recent changes to the landscape.

Last week, I discussed in depth the price declines of CRF and the Cornerstone Strategic Value Fund (NYSEMKT:CLM). The price declines of both funds were no surprise to me; I warned CEF Insider subscribers to avoid both funds in March of this year; both are down about 6% since then. The sudden decline in these funds' prices was a result of the indiscriminate capital flows into both in recent weeks, which was a symptom of the broader problem that is plaguing equity CEFs: discounts going down. Discounts have plummeted from 7.6% in late March, when I warned subscribers of the top in these funds, to 5.47% as of last week, according to CEFA:

Source: Closed-end Fund Association

Surprisingly, however, discounts for the last week actually got bigger on average despite the dramatic drops for CLM, CRF, and PGP. While some investors are selling off the heavily premium priced top-10 funds, investors are also buying some of the less but still premium-priced CEFs out there.

Thus the problem of overbuying premium-priced funds has not disappeared despite the recent "improvement" in market valuations for CLM, CRF, and PGP.

In bond funds, we are seeing a more stable trend of gradually shrinking premiums, although we aren't much far off late March's 4.4% discount average to our current 3.29% average:

Source: Closed-end Fund Association

Again, CEF Insider subscribers will know that I have been more constructive on bond funds in recent months after being more positive on equity funds earlier in 2017, and this is partly why. While we're seeing smaller discounts across the board, the rate of change is less extreme because the market did not aggressively over-correct a big sell-off earlier this year in bond funds to the same extent as they did with equity funds.

Looking ahead, these trends indicate that there may be more opportunities in bond funds than equity funds in the short term, although some discounted equity funds remain attractive purchases if they demonstrate NAV appreciation and relative undervaluation on a longer time horizon, as seems to be the case with ISL. However, the risks of smaller funds like ISL due to low liquidity should also be a factor that CEF investors, especially buy-and-hold investors, take into account before jumping into a fund like this.

Disclosure: I am/we are long BIF, USA.

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.