CEF Investing: Is Your Stomach Strong Enough?

by: Alpha Gen Capital
Summary

The current volatility is something that has been absent from the market for a number of years.

Closed-end funds often exhibit an illusory amount of risk/volatility given that the prices are supply and demand driven largely by retail investors.

The NAV movements are the true measure of the volatility of a closed-end fund.

Nothing so undermines your financial judgement as the sight of your neighbour getting rich.
—John Pierpont Morgan

The quote above from J.P. Morgan is probably one of the most important, but also understated, in the financial world today. If anyone has read Ron Chernow's landmark book "The House of Morgan: An American Banking Dynasty", you would understand that Morgan kept emotions out of his decisions. While he always looked for an edge (and believed competition was folly) his actions were largely based on a view of long-term buying at times of volatility.

Most investors today are focused on returns and volatility, a measure of risk. While those are important factors, many do-it-yourself investors feel like risk premiums should come for free. In other words, we should be getting a risky asset's return for risk-free assets.

Investors tend to like stuff that only goes up- and rightfully so. Who doesn't want to generate nice returns without any downside risk? The problem is this is the real world, not fantasyland. If there were truly no risk, the market efficiency mechanisms would pour money into it to the point where the future expected return equaled the risk free rate.

Having been in the wealth management industry for a long time, we know how the typical client and investor tends to think. If we had a nickel every time a client said that they wanted to buy rental property as the income is stable and the "principal" doesn't move. But just know this is an illusion that satiates a behavioral trait. The illusion is the notion that the "principal"- the home value- doesn't move or moves like a glacier.

This is patently false. The value of the home is moving daily- even hourly based on mortgage rates, demand, supply (how many homes nearby are on the market), and a host of other factors both macro and micro. But the illusion that the value doesn't change helps create the misconception that the principal is not really at risk.

The second notion in regards to the above thinking is that a house (or any 'real' asset) is not at risk. A home does carry a certain amount of risk of loss- similar to a bond defaulting- including the geography coming out of favor, destruction, economic, etc.

But that hardly changed many investors' minds. Not having to open your monthly statements- or worse yet, login to your brokerage each day- and see a "change in value" that was down can provide a significant support artifice to the psyche. That is something that has to be dealt with if you are going to be a passive investor in the public markets.

Given that we specialize primarily in the closed-end bond fund space, we are dealing with this every day. Individual bonds are similar to owning real estate in that they typically do not move much on a day-to-day or even month-to-month basis. The investor collects the coupons and is satisfied seeing that their principal is virtually unchanged.

Since 2008 with interest rates cratering, the yield on typical individual and mutual bond funds are down significantly. This has sent investors on the hunt for yield over the last decade to earn something more than 1-3% on their bond allocation.

Many investors found closed-end fund as a space that was previously unknown to them. Lured by the higher yields, they bought funds that sported distributions in excess of 8%- which on paper looked so much better than 3% (we are math experts!). But what they didn't understand is the added risk.

In August of 2016, we wrote a report titled,"CEF Price Risk Is Opportunity; NAV Movements Are The True Measure Of Risk." In it we noted:

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.

Just like in housing where this is a misconception of low volatility, there is an illusion in the closed-end fund market. However, unlike in housing, this illusion causes investors to perceive the risks of CEFs as being greater than it truly is.

We broke out the taxable bond categories and analyzed the 3- and 5-year standard deviation of price and NAV. We also added the average standard deviation of the discount. In other words, how variable the discount of a CEF moves around.

Remember, the volatility of the price of a CEF on a day-to-day basis has no real bearing on the true value of the position. It is simply supply/ demand in the market; a lower liquidity market at that. We estimate that about 90% of the move in the price of a CEF is purely emotions-based. In fact, we see significant movement in prices due to the volatility in the equity market (as measured by the VIX index).

Looking below, you can see how much more volatile a CEF appears (based on price) compared to the true value (based on value). For example, high yield has an average 5 year standard deviation on price of 11%. That is more than double the volatility of the corresponding NAV of the funds. The illusion is the price movements of the shares that are the true risks of the position.

You can see that often times, the volatility of the price is more than double that of the NAV. Running our marketplace, which focuses a lot on closed-end bond funds we run into this all of the time. We even wrote a piece on it called "Understanding The Performance of Your Closed-End Funds" which highlighted the illusion that can cause contempt in CEF investors.

For the most part, brokerages rarely have a "total return" field in their dashboards, if they have it at all. Instead, you see "Capital Gain/Loss" which is calculated by multiplying the number of shares times the ending price, minus shares x initial purchase price. The problem is that the overwhelming percentage of the total return comes from the distributions which are not incorporated into that formula. In some cases, distribution make up more than 100% of the total return meaning there's often a capital loss (this often stems from a managed distribution policy).

If we had a nickel for every time someone messaged us saying they were down 7% on ticker XYZ, and then asking what should I do? The first thing we would typically ask is if the 7% includes the distributions or not. Nine times out of ten, it does not. Given that these funds distribution yields in excess of 7%, if the fund was held for a year, then the investor is at least even.

From our article two-plus years ago:

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.

Concluding Thoughts

The standard deviation of NAVs provides us a measure of risk. While some NAVs are artificially less volatile given the liquidity of the underlying assets, that doesn't differ much from an individual bond that rarely trades. Some investors simply cannot handle owning individual stocks or CEFs which jump around a lot. For a CEF investor, the NAV is the true measure of volatility and how a fund is positioned.

During the second week of October, we saw a significant decline in prices as the largely retail investor base in CEFs all ran for the exits at the same time. The plethora of sellers and the dearth of buyers sent prices down sharply. This is not uncommon in periods of volatility and/or rising rates. But this presents a buying opportunity.

We sent our members a note that titled, "YH: Don't Panic!" in which we stated the following:

Remember the goal of the Core Portfolio is strong cash flows of around 8%. That of course doesn't come without risk. However, by staying the course, the cash flows from the portfolio will eventually overwhelm the price distortions that can occur. The NAVs are showing that the value in the funds is holding up. Today, discounts remain very wide, especially in anything with duration because of the fear of rising rates.

But as bond funds, they have a terminal value so long as the underlying issuer does not default. They are tethered to the NAV and when in favor, will revert back towards those values. We have purchased cash flow vehicles that pay real dollars so unless the distribution is cut, nothing has changed. Even the value of the underlying holdings barely moved yesterday in what was one of the worst days for the market ever.

The moves in the last few days are complete panic by largely retail investors looking to sell anything that could even remotely be affected by rising rates. Advocating to stay the course when hysteria is all around is tough to do but it is the rational and logic choice.

Taking advantage of these volatile periods by buying when there is a sea of red on the quote screen can be one of the toughest things to train yourself to do. That comes with experience and knowledge. A large part of our service is about education and generating trading experience. By doing so, we are training our members to be opportunistic and ignore the noise- which is what we saw most of the recent gyrations as being.

But some investors simply can never get to that point where they are comfortable with ANY loss to their portfolio. Those investors should be individual bonds and open-end equity mutual funds. They should also look at things like certificates of deposit (CDs) since those also have no price fluctuations. This is not to say you shouldn't be at least a little nervous about volatility. But if it keeps you from sleeping every night worrying, even on days when the market is calm, then there is clearly a disconnect between the portfolio risk and your risk tolerance.

Today in the CEF space, we are seeing this with more frequency. The prices of some of these bond funds are trading at deep discounts despite the NAVs being virtually unchanged in the last couple of months. To us, this is exactly what we want when looking to add these to our portfolios. If the value of the fund is holding up despite rising interest rates and increased credit spreads, but prices are down 2%-5%, then all you've done is picked up higher yielding positions with a larger margin of safety.

With the Core Portfolio now yielding almost 8% (tax equivalent) with the largest discounts in over 2 years, we believe this is a great opportunity to de-risk your equity/dividend heavy portfolio a bit and re-allocate towards bonds. As our table shows above, most NAVs have standard deviations of 5% or less, roughly one-third that of the equity markets.

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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.