Are CEF discounts rational?

[wabmester]

I've looked at a few CEF's that are trading at pretty deep discounts vs NAVs.   Most of these have various nasty gotchas: high fees, high leverage, and artifically high yields via return of capital.

But even after factoring in the nasties, they seem like they *might* be cheap.

For example, RTU (Cohen & Steers REIT and Utility Income) seems reasonable to me.   The 1.27% ER and 34% leverage is offset by a 15% discount.

Is that a good deal?  How do you value a CEF?

 

[haha]

I've looked at a few CEF's that are trading at pretty deep discounts vs NAVs.   Most of these have various nasty gotchas: high fees, high leverage, and artifically high yields via return of capital.

But even after factoring in the nasties, they seem like they *might* be cheap.

For example, RTU (Cohen & Steers REIT and Utility Income) seems reasonable to me.   The 1.27% ER and 34% leverage is offset by a 15% discount.

Is that a good deal?  How do you value a CEF?

I have been using CEFs for many years. Other than the speculative chance that it may open end, I think the usual discounts are about right to compensate for high fees.

One that I do not feel this way about is Adams Express. I own it, and when I want more broad blue chip exposure I will own more. The exp ratio most years is <0.5%, and the discount is often close to 15 %. Management is as good or better than most others.

You almost gain free leverage on just the income dividend alone. If you posit a even a fairly low total return, you gain significant free leverage. Another subtle point (to me at least it is subtle) is that payouts whether income or CG or whatever are hyped by the fact of your leverage. Thus, if you have a 15% discount going in, and they make a 1 dollar distribution say $1 on a $10 NAV, since you only paid $8.50 for your $10 stock, the distribution that comes out of the company at 10% is perceived by you as a 10/0.85= 11.76%.

Not bad for a low risk no work deal.

One thing to remember is you should own it in a tax sheltered account, as they have years of unrealized capital gains in their portfolio due mostly to very low turnover.

Ha

 

[brewer12345]

Further to what Ha said, I dabble in these things occasionally. I will usually pick on one or two funds that have an underlying exposure I like and a sane approach to leverage and portfolio management. Then I watch and wait. When the CEF approaches its max discount in recent (1 or 2 years) history, I will buy some. I particularly like PDT and HPF in part because these funds have one very large owner that has a history of buying up a majority and forcing liquidation if the discount gets too big.

 

[Bimmerbill]

I find these fascinating. I took "Investment Management" last semester as part of my MBA program and the instructor talked about them and Malkiels book.

Reading more about them has been on my to do list.

 

[lazyday]

If the yield and discount are both high, that can make up for a high e/r. (A discount acts like leverage on the yield.)
You could use that to value a cef...at least I used to use it as part of a valuation; can't say if it worked well or not, since there was so much noise in discounts moving all over the place.

I used to spend a lot of time following cefs. Tracked discounts, er, valuations, institutional ownership, upcoming votes, etc, as best I could in spare time.

Easy to get burned if you're not careful. Greedy management will screw you with rights offerings, and outside institutions you think will make things better don't always. At least not on the schedule people expect. (For example, Ron Olin didn't do what many expected.)
Management knows that unlike with open end funds, investors can't take their $ away, so some take advantage. Some people have complained that corporate governance in cefs is a sham; they are run for management profit and not for shareholders. Not saying they can't be great deals, just that it's a little like making a deal with the devil.

If discounts get back above 25-35% again on several US listed cef's (not just the venture capital ones) I'll start looking again. I just can't get excited about 15% with 1.27%E/R, at today's low yields.

 

[wabmester]

If the yield and discount are both high, that can make up for a high e/r. (A discount acts like leverage on the yield.)

That's how I see it.   I'm not looking for discounts in the hope that someday the discount will narrow and I'll juice my cap gains.   I'm looking for a higher yield on my initial investment.   A 20% discount on a fund with a 5% yield on NAV means you're getting 6% yield on your investment, which would make a 1% ER "free."

But it's hard to factor in some of the other nasties.    I have to wonder if the market is smart enough to pick the "right" discount.   If you take Ha's example of ADX, it's selling at a 15% discount and has an ER of 0.45% with no leverage.   It's hard to see how that discount could be rational.   Although ADX does seem to consistently underperform the market, so that may be a factor.

 

[laurence]

durh....what's cef?

Adams Express, wow, I know that name from my grandparents, Gpa kept DCAing into it through thick and thin. They retired early and though he passed away a few years ago, Gma keeps traveling the world and speaking glowingly of good old Adams Express.

 

[wabmester]

durh....what's cef?

Closed-end funds.   They are almost always rip-offs when newly issued, but they often become more bargainish once they trade on the open market.

Check out www.etfconnect.com, which will let you sort them by discounts.

 

[Danny]

Adams Express....Now that's a company that transformed itself into something completely different.....started as an Express company like Wells Fargo (the 1800's versions of Fedex & UPS) in 1840...1929 what a year! they decided to become an investment company and have been a CEF for most of the time since....Adams - a $1.2 Billion CEF.... Wells Fargo - somewhat bigger......what a difference management and vision can make.....still a decent return for Adams over the years...I am wondering how WFC compares over same time frames though...

 

[laurence]

Thank you, Wab!

 

[lazyday]

I have to wonder if the market is smart enough to pick the "right" discount.

Not sure.

There's supposedly a lot of dumb money: people who are sold these things, and then sit on them, and either never vote or blindly vote with management.
As evidence, you can look at how people actually vote against their own interest.

Then there's the multitude of small players like those on this board or http://finance.groups.yahoo.com/group/closedendfunds2/, of varying sophistication, and with different strategies, who try to profit from the discount in a few different ways.

Higher up the chain is the institutional money, places like Harvard, Lazard, Bank Berlin, Opportunity Partners, City of London, etc, with tons of money to throw around. (Well, OP may not be that huge)
These institutions should have the resources to get valuations right. Not sure of this, but I suspect they most often invest in funds they hope can be forced to open end or liquidate, or at least can be pushed into shrinking the size of the fund to narrow the discount. Which leads to the top of the food chain:

Entrenched management. Shareholders like Harvard are usually no match for the de facto owners of the cefs, the management. They will often use every trick in the book, and use shareholders' own money, to fight off those pesky shareholders and maintain their lucrative position.

Sometimes the discount is an expression of the probability of survival of management.

For funds which have little institutional ownership and little chance of open ending, perhaps the price is more likely to diverge from the "correct" price?

Two more comments:

-Rights offerings cost real money. The investment banks take a significant cut off the top, and this is an ongoing cost of owning many cefs, on top of the hidden costs of trading and explicit costs of ER, one should account for. In some cases, you can reduce this cost (or even profit) by oversubscribing, but not always IIRC. (Would depend on how much you can oversubscribe and at how much discount, compared to how much dillution caused by the investment bank's cut. And you won't know ahead of time.)

-The movement of the discount can be a big source of profit or loss. I wouldn't count on big profit from it from today's meager discounts, but in the past it has been very good to me, sometimes when the market hasn't!
Of course if the discount increases by 15%, you can just stay put and happily pocket the dividends, if you bought in cheap enough so the yield was decent even after ER and rights offerings, based on initial discount.

(I haven't been following Adams Express)