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Some observations on closed end funds i.e. CEFs.
Old 05-25-2016, 01:38 PM   #1
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Some observations on closed end funds i.e. CEFs.

I have just started investing into CEFs and have made some observations.

First, if you can buy into a CEF at a large enough discount you can all but eliminate the expense ratio difference between a CEF and an ETF covering the same area.

Here is my logic:

Let's say we have a CEF fund A that has an expense ratio of 1% and an index ETF fund B that has an expense ration of .10%. At first glance you would say that A is much more expensive to own than B, but that is not necessarily true as A is a CEF which happens to currently sell at a discount of -12%. In such a case, fund A is actually cheaper than B... Observe...

A 1% higher ER means that a fund is more expensive by 1% for the entire year.... there are 12 months in a year... so if you can purchase something at a -12% discount that is equivalent to -1% for each month of the year. Therefore...

A -12% discount is the equivalent of a -1% to ER...

In my example the expense ratio of A is actually 0% and the ER of fund B is .10%...
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Old 05-25-2016, 01:46 PM   #2
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Second observation...

If there was ever a time to use leverage it is NOW when rates are near zero... CEFs typically have leverage in the 30% range and this is managed by a professional, i.e. not me.

So logically now is a great time to buy CEFs and lever up...

Lastly, observation three... CEFs have a number of nice features...

Because CEFs do not have to issue/redeem new shares all the time like an open ended fund, they will not be forced to sell assets in a market panic.

CEFs can employ options strategies to enhance yield such as selling covered calls.

CEFs are very flexible when it comes to making distributions. For example I am buying CEFs that make monthly payments of 100% of the income and not dipping into principal. This is very nice for me, an income investor, to have monthly cash flow like I would have if I owned the individual stocks myself.

CEFs can invest in assets like MLPs (up to 25%) and still remain a registered investment company (RIC). That means no K-1s for me while also not paying corporate tax on the MLPs as a c-corp would have to do (which is how MLP etfs do it).
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Old 05-25-2016, 03:13 PM   #3
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Originally Posted by ESRwannabe View Post
Second observation...

If there was ever a time to use leverage it is NOW when rates are near zero... CEFs typically have leverage in the 30% range and this is managed by a professional, i.e. not me.

So logically now is a great time to buy CEFs and lever up...

Lastly, observation three... CEFs have a number of nice features...

Because CEFs do not have to issue/redeem new shares all the time like an open ended fund, they will not be forced to sell assets in a market panic.

CEFs can employ options strategies to enhance yield such as selling covered calls.

CEFs are very flexible when it comes to making distributions. For example I am buying CEFs that make monthly payments of 100% of the income and not dipping into principal. This is very nice for me, an income investor, to have monthly cash flow like I would have if I owned the individual stocks myself.

CEFs can invest in assets like MLPs (up to 25%) and still remain a registered investment company (RIC). That means no K-1s for me while also not paying corporate tax on the MLPs as a c-corp would have to do (which is how MLP etfs do it).
You make many good points. Like you, I also figured out that with enough discount, even relatively high expense ratios become small or disappear. Even a return of capital payout is positive if the fund has a discount, because you are in effect redeeming at face value a coupon bought at discount.

Still, one aspect of leverage is that market downturns are magnified, so I think one still needs to remain conscious of valuations, if valuations are on the radar.
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Old 05-25-2016, 03:16 PM   #4
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Quote:
Originally Posted by ESRwannabe View Post
.....Here is my logic:

Let's say we have a CEF fund A that has an expense ratio of 1% and an index ETF fund B that has an expense ration of .10%. At first glance you would say that A is much more expensive to own than B, but that is not necessarily true as A is a CEF which happens to currently sell at a discount of -12%. In such a case, fund A is actually cheaper than B... Observe...

A 1% higher ER means that a fund is more expensive by 1% for the entire year.... there are 12 months in a year... so if you can purchase something at a -12% discount that is equivalent to -1% for each month of the year. Therefore...

A -12% discount is the equivalent of a -1% to ER...

In my example the expense ratio of A is actually 0% and the ER of fund B is .10%...
Not sure you math makes sense... you seem to be confusing months and years.

Also, you seem to be assuming that you will later sell at NAV (the discount will go away) and this may not necessarily be true.

It seems to me that it the discount stays constant then the ER is 1%.
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Old 05-25-2016, 03:46 PM   #5
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Originally Posted by pb4uski View Post
Not sure you math makes sense... you seem to be confusing months and years.

Also, you seem to be assuming that you will later sell at NAV (the discount will go away) and this may not necessarily be true.

It seems to me that it the discount stays constant then the ER is 1%.
OP's analysis may or may not be correct, I did not go through his reasoning. I use a spreadsheet that simplifies everything to actual cash values, and unless I have errors in this an expense ratio of 1% or so disappears somewhere around a 15% discount on purchases price even if you never sell it. Clearly if you hit a huge bear market and have to sell at larger discounts than you went in, you may well get a loss.

The positive effect is clearer with bigger discounts, and at times we have seen and will likely see again some huge discounts. Not only can the fund expense be netted out, the yield on cash invested can be more than the gross yield on the underlying portfolio.

I don't know how to copy spreadsheets, but just grab some discount, try 20%, and see what you find? I hope you will post it as a check on my analysis.

If we ever get reasonable valuations and good discounts again, I think a collection of these will be my permanent low maintenance portfolio.


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Old 05-25-2016, 04:04 PM   #6
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Thank you both for the comments. So my logic is based on not selling the shares but holding forever and collecting the income thrown off. If you go to sell then you would need the market price and NAV price of the CEF to be equal to each other to take advantage of the discount.

However if you simply hold the shares indefinitely then you only have to get the timing on the discount right one time (when you buy it).

In my example fund A has an ER of 1% and that is a permanent. If fund B has an ER of .10% then that means A has a permanently higher ER of .90%. However, if one buys in at -12% discount and holds forever, then that discount is also permanent and it offsets 1% of ER fees.

Think of it this way. When you buy in at a discount it is also like I am buying 12% more of the asset in fund A than in fund B. That doesn't go away if I continue to hold the asset indefinitely or choose to sell it when the discount is at 0%.

Clear is as mud?
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Old 05-25-2016, 04:04 PM   #7
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I don't think it works. Below assumes that you have a choice of investing $1,000 in a) a mutual fund with a .1% ER or b) a CEF at a 12% discount to NAV that has a 1% ER. You hold it 10 years and then sell and the discount stays the same at 12%.

Numbers assume that in each case that the underlying assets earn 10% annually. The return for the fund is 9.9%/year and for the CEF is 9%/year, in each case the 10% return on the underlying assets less the ER.

The only way you can come out ahead is if the discount narrows.

  CEF 
 FundNAVFMV
Balance 1,000.00 1,136.36  
ER0.10%1% 
Assets earn10%10% 
Discount  -12%
0 1,000.00 1,136.36 1,000.00
1 1,099.00 1,238.64 1,090.00
2 1,207.80 1,350.11 1,188.10
3 1,327.37 1,471.62 1,295.03
4 1,458.78 1,604.07 1,411.58
5 1,603.20 1,748.44 1,538.62
6 1,761.92 1,905.80 1,677.10
7 1,936.35 2,077.32 1,828.04
8 2,128.05 2,264.28 1,992.56
9 2,338.73 2,468.06 2,171.89
10 2,570.26 2,690.19 2,367.36
    
Return9.90% 9.00%

Edited to add: Actually if each fund distributes all earnings each year then the CEF does come out ahead after a while because the distributions are higher each year.
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Old 05-25-2016, 04:07 PM   #8
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Originally Posted by pb4uski View Post
I don't think it works. Below assumes that you have a choice of investing $1,000 in a) a mutual fund with a .1% ER or b) a CEF at a 12% discount to NAV that has a 1% ER. You hold it 10 years and then sell and the discount stays the same at 12%.

Numbers assume that in each case that the underlying assets earn 10% annually. The return for the fund is 9.9%/year and for the CEF is 9%/year, in each case the 10% return on the underlying assets less the ER.

The only way you can come out ahead is if the discount narrows.
If the portfolios of the two investments are similar, wouldn't the yield before expenses on the CEF be 13.6% higher because of the discount? Otherwise, why invest in the CEF? (edited to correct the math)
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Old 05-25-2016, 04:15 PM   #9
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"If we ever get reasonable valuations and good discounts again, I think a collection of these will be my permanent low maintenance portfolio."

Now that I understand the benefits of CEFs I also plan to make them permanent holdings. I have a mixture of assets (CEFs, open ended funds and ETFs, individual holdings, etc).

What I will look for in CEFs is to buy when the discount is large enough to offset the higher ERs and make them comparable to ETFs. IMHO a CEF is "better" than an ETF of the same ER depending on the situation. For example right now with low rates I prefer CEFs so that I get leverage. All things in moderation of course.

Leverage is not a free lunch and I know that the volatility will be higher during market panics. However counterintuitively I also know that during a market panic the CEF itself is not being forced to sell assets at a loss because there is no forced share redemption. The increased volatility will be from fellow share holders panicking and selling on the secondary market.

Even though this is kind of trivial. I really like the CEFs that pay monthly distributions. Psychologically I like seeing monthly cash flow.

In a way, investing in CEFs can be similar to investing in real estate. Both are using leverage to juice returns, and in both of them you can focus on the monthly cash flow.
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Old 05-25-2016, 04:24 PM   #10
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pb4uski,

I'm not following the chart very well, but my assumptions are: (1) no reinvestment of dividends (those are spent) and (2) no selling of shares but holding indefinitely.
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Old 05-25-2016, 04:31 PM   #11
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If the portfolios of the two investments are similar, wouldn't the yield before expenses on the CEF be 13.6% higher because of the discount? Otherwise, why invest in the CEF? (edited to correct the math)
Yes, the earnings would be 13.6% higher... but the ER would be .9% higher... assuming that all earnings are distributed it looks like the breakeven point would be 6.6% earnings rate....above that the higher earnings offset the higher ER, below then no.
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Old 05-25-2016, 05:26 PM   #12
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If the portfolios of the two investments are similar, wouldn't the yield before expenses on the CEF be 13.6% higher because of the discount? Otherwise, why invest in the CEF? (edited to correct the math)
This is the key to the advantage.

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