Negative retail investor psychology has crushed the prices of closed-end funds. They are trading at unusually large discounts to NAV (net asset value). It’s an historic opportunity worth exploiting.
Quick Background on Closed-End Funds
What are closed-end funds? Briefly, they are mutual funds that have a fixed number of shares and trade during the day on exchanges like stocks. They differ from open-end mutual funds that are bought and sold in direct transactions with the fund company at the value of the underlying portfolio or net asset value (NAV). They also differ from exchange-traded funds (ETFs) which like closed-end funds also trade on exchanges, but because ETFs can increase or decrease shares outstanding, ETFs trade at prices very close to NAV.
In addition to trading at prices that may differ from NAV, closed-end funds also differ from open-end funds and ETFs in that closed-end funds may utilize a limited amount of leverage. The average amount of leverage among closed-end funds utilizing structural leverage is 26%.1 Structural leverage increases the amount of assets owned by the fund. For example, a $100 investment in a closed-end fund with 40% structural leverage will have a portfolio of $140 in assets and $40 in debt. About half of closed-end funds issuing debt do so in the form of preferred stock, and about half use other forms of debt such as bank loans or lines of credit.
Because institutions such as closed-end funds can borrow at much lower interest rates than individuals, owning closed-end funds is an economically attractive way for individual investors to obtain leverage. As long as the rate paid on the debt is lower than the return on the assets purchased with the debt, the fund will enhance its return with leverage. If the opposite is the case, the fund will magnify its losses. The use of debt increases the risk of a closed-end fund. About two-thirds of closed end funds utilize some form of debt. It is more common for bond funds to use debt and less common for equity funds.
The Closed-End Fund “Puzzle”
For decades, academic researchers have described the behavior of closed-end funds as a “puzzle” in that it presented a clear-cut challenge to the usual assumption of market efficiency. The central question is “why do CEF prices deviate so dramatically and persistently from NAV?” The NAV is an unambiguous indicator what the CEF’s portfolio is worth. However, standing between the CEF share owners and the CEF portfolio is a layer of management. This layer of management is compensated by fees, which reduce the value of the CEF shares. On the other hand, the management may enhance the value of the CEF through its astute trading of the portfolio. CEFs are usually brought to market through an IPO only if there is a perception that the CEF management has an unusual degree of skill. The fact that CEFs almost always trade a discount to NAV within a year of their IPO indicates that these initial hopes prove unfounded. Thereafter, CEF prices reflect the tug-of-war between the hoped-for value that the managers of these funds may be able to add and the fees that they charge for their services.
CEF prices are determined by supply and demand, just like the prices of the underlying assets in the portfolio that go into calculating the NAV. However, whereas the primary owners of the underlying assets tend to be institutions, the owners of CEFs are primarily individuals. The latter are presumably more subject to emotional biases. During an IPO, CEFs are heavily promoted by financial intermediaries who are compensated by the CEF issuer, a cost indirectly born by the initial purchasers of the CEF shares. A cynic may describe the former as wolves and the latter as sheep. A rational and informed investor would not buy a CEF at its IPO knowing that its price will drift down to a discount to NAV as surely as summer becomes winter.
CEF discounts and premiums continue to be subject to retail investor emotion well after the IPO. Academic evidence suggests that recent performance influences a CEF’s discount due to overreaction by retail investors.3 Other than at their initial issuance, CEFs tend to trade at a premium to their NAV when the underlying assets are considered both desirable and difficult to obtain, such as closed-end country funds that invest in countries with restrictions on foreign investors, single-state municipal funds with highly illiquid municipal bonds, or high-yield bond funds that own private or illiquid debt.
There would seem to be an arbitrage opportunity between CEFs and their underlying assets. Why don’t some institutional investors simply buy the CEFs and short the underlying assets and thereby earn a risk-free arbitrage return? There are several impediments that prevent this. First, CEFs are thinly traded and even modest transactions can involve significant bid-ask spreads. Second, the bid-ask spreads for the underlying assets are also very significant in many cases. Most CEFs focus on relatively illiquid assets, thereby taking advantage of the more stable operating environment that a permanent capital base affords them compared to open-end funds. Third, there are regulatory limits on the percentage of a fund that a single owner can have before certain disclosures and restrictions start to apply. Owning a small minority of the outstanding shares in a CEF will still subject the arbitrageur to significant risk that the CEF’s discount to NAV may widen rather than contract. In the final analysis, CEF arbitrage is just not profitable enough nor scalable enough to attract significant arbitrage capital.
Buying at a Discount Increases Expected Return
However, the limits to pure arbitrage do not mean that investors of more modest size should not take advantage of the information provided by CEF prices compared to their NAVs. Several well-received academic papers have shown this information to be potentially quite valuable.2 My own research has shown that NAV discounts in CEFs are exceptionally strong indicators of value and predictors of future performance. Unusually large discounts to NAV tend to mean-revert back to more normal levels of discount. When that happens, the returns of CEF investors who bought at a discount will be boosted.
However, even if the NAV discount never mean-reverts, it still makes sense to take advantage of a large NAV discount. Let me illustrate. Assume that the NAV of a CEF is $10 per share. Also assume that the CEF portfolio generates economic benefits (current and future growth in dividends, earnings, cash flow, etc.) of $1 per share each year. (Bond CEFs tend to have more current dividends and stock CEFs tend to have lower current dividends and more growth in future dividends, but what matters is the long-term economic benefit per share.) Thus, what we’ll call the “economic yield” is 10% per year: $1 per year of economic benefits / $10 share price. If that CEF is selling at a 10% discount and its price is $9 per share, the economic yield is now 11.11%: $1 per year of economic benefits / $9 share price. Even if the NAV discount never closes, the owner of the CEF share will continue to earn an economic benefit of 11.11% per year assuming that the portfolio holdings are able to generate a constant rate of economic benefit.
The Current Exceptional Opportunity
The reason that now is a good time to invest in closed-end funds is the fact that their prices have rarely been so low relative to their NAVs. The graph below shows the history of the average discount levels for the major U.S. closed-end fund groups since the depths of the 2008 Great Recession through last Friday, March 20, 2020.
Using high-yield CEFs as an illustration, the graph below shows the history of the average NAV discount for all of the high-yield closed-end funds in the U.S. (Currently there are 59.) As of last Friday, the average NAV discount of this group was 23.4%! Over the trailing 5 years, the average discount had been 8.2%. The current level is more than three standard deviations above average. Statistically speaking, this occurs only about less than .15% of the time (assuming a normal distribution).
The coronavirus bear market has been a classic case of CEF discount widening. Investors are worried about a global economic recession. Global stock markets have reacted with significantly negative returns. Most markets, including here in the U.S., are down about 30% from recent highs. And the speed of the decline has been unprecedented. There has been a stampede to cash. The panic has been particularly strong among retail investors. Closed-end funds appear to have been dumped with little regard to price relative to the value of the underlying portfolio.
It is logical for stock and bond prices to correct in the face of adverse circumstances. However, closed-end fund prices have declined much more than the prices of the assets they own. Is this a sign that CEF owners are better at forecasting further problems ahead for the underlying assets than do their institutional owners? Or is it an indication that CEF owners became discouraged and sold at heavily discounted prices for emotional reasons? I believe that the weight of evidence is with the latter theory.
The long-term odds favor those willing to go against the crowd. Buying a fund at an unusually steep discount to the value of its underlying portfolio couldn't be a clearer or more compelling value play. In fact, among the various value, momentum, and quality factors that I use to select funds, nothing comes close to the power and consistency of the NAV discount factor.
How can I be so confident that investing in CEFs with unusually large NAV discounts will be a winning strategy? Because I have thoroughly tested it. The graph below illustrates just one of the tests, as applied to the high-yield CEF universe. The blue line is the cumulative residual return (net of our proprietary four-factor risk model) of an equal-weighted portfolio (20% each) of the five high-yield CEFs with the largest NAV discounts. The portfolio is reselected monthly. Since 2002, the average residual return (net of risk effects such as equity market and interest rate betas) has been 8.0% per year. The orange line is the same thing but investing in the five with the smallest (or most negative) NAV discount. That annual return has been -13.6%. The green line is a long-short implementation of the strategy. Its return has been 20.6% per year. The results have been both strong and consistent.
Most other closed-end fund groups show similar results from a strategy of investing in those with the largest discounts to NAV. Results can be improved further by comparing the current NAV discount to the historical average discount for that CEF, buying only those with an unusually large discount relative to that CEF’s own history.
A Few Examples
As of Friday, the NAV discounts were much larger than average in all CEF groups. For example, the average discount for international equity CEFs was 19.4%, and for international fixed income CEFs it was 12.2%. U.S. equity CEFs had an average NAV discount of 14.7%, and for U.S. fixed income funds it was 11.3%. The opportunity for creating a diversified portfolio of closed-end funds selling at substantial discounts is unusual and attractive.
Of course, there is much more than simply the NAV discount that should be considered before investing in a closed-end fund, including: 1) the investment philosophy and strategy, 2) the portfolio characteristics, 3) the amount and cost of leverage, 4) the expense ratio, including management fee and interest expense, 5) the bid-ask spread, and 6) the exposures to risk factors such as the equity market, interest rates, the U.S. dollar, and oil prices. However, to show that it is possible to use CEFs for a very wide variety of portfolio applications, and to provide examples of how deep the current NAV discounts are, here is a list of a few using Friday's closing prices and NAVs:
2Jeffrey Pontiff, “Closed-end fund premia and returns: Implications for financial market equilibrium,” Journal of Financial Economics, 37 (1995) 341-370. From the abstract: “Funds with 20% discounts have expected twelve-month returns that are 6% greater than nondiscounted funds.” Patro, Picotti, and Wu, “Exploiting Closed-End Fund Discounts: The Market May Be Much More Inefficient Than You Thought,” 2014 working paper. From the abstract: “We find significant evidence of mean reversion in closed-end fund premiums…Our strategy of buying the quintile of funds with highest expected returns and selling the quintile of funds with lowest expected returns yields an annualized arbitrage return of 18.2% and a Sharpe ratio of 1.918.”
3Elroy Dimson and Carolina Minio-Paluello, “The Closed-End Fund Discount,” The Research Foundation of AIMR, 2002.