Written by: Nick Williams | AAM
Closed-end funds are actively managed investment companies that issue a finite number of shares through an IPO (Initial Public Offering) and are generally traded on an exchange in the secondary market. For this reason, they tend to trade at discounts or premiums to their reported Net Asset Value (NAV).
Of course, the NAV simply represents the aggregate value of holdings in the portfolio. This can change as asset values appreciate or depreciate but tends to be less volatile than the actual market price of the closed end fund shares.
The discount/premium reflects the difference in the reported NAV from the value the secondary market places on those shares which often trade on the secondary market at a discount to the NAV. Historically, the average discount has been between 4–5% for the closed end universe. This discrepancy is largely a reflection of investor sentiment due to factors such as uncertainty, perceived liquidity, or the general appetite for assets owned within the fund.
When analyzing closed-end funds, most investors focus on two primary components:
- The level of distributions (income)
- The discount/premium to NAV
The level of distributions is relatively straight forward. Distributions are passed along to investors as dividends, interest income, or capital gains generated from fund holdings. These distributions vary depending on the strategy but have historically averaged in the range of high single to low double digits. A notable pick up to most income-producing counterparts such as dividend stocks or corporate debt. We would also emphasize the sustainability or growth of those distributions as an important consideration.
To maintain their tax status, closed-end funds must distribute at least 90% of their net investment income to investors. This means that income is by far the largest driver of returns (far exceeding price return) over the long term. For this reason, we believe the level and sustainability of income should be the primary consideration.
While income sits in the driver seat, price appreciation garners a lot of attention and is generally evaluated on the basis of the discount/premiums to NAV. This can be a bit more difficult to discern. The basic premise of investing in a pool of assets at a cost below their reported values seems logically appealing. But if the NAV reflects one value, why then is the market price telling a different story?
Remember that the discount to NAV is largely a reflection of investor sentiment. Investors might shy away from a fund if they have a negative outlook for a given strategy or asset class, or they feel the level of distributions may not be sustainable. Closed-end funds typically employ leverage that amplifies both gains and losses, is leverage too high causing too much volatility? Or is that leverage becoming costly and weighing on returns? Investors may also believe the NAV doesn’t reflect the true value of assets in the fund. These would all lead investors to place a deeper discount on the shares in the secondary market.
Certainly, these are all legitimate concerns that every investor should consider prior to investing in closed-end funds. However, we should not forget that these concerns are based on how investors perceive these risks. In other words, a deeper discount would be indicative of investor sentiment that is relatively pessimistic.
If you’ve heard it once, you’ve heard it a thousand times….
“Be fearful when others are greedy, and greedy when others are fearful.”
A discount to NAV that is wider than its historical norm likely suggests that investor sentiment is pessimistic. The deeper the discount, the more pessimistic investors appear to be.
Over time, we see this discount to NAV oscillate (narrower in good times, wider in not-so-good times). If this measure — at least in part — reflects investor sentiment, then following one of the most foundational concepts of value investing should, in theory, serve as a convenient indication for us to consider.
To be clear, we are not advocates of overly active market timing. We subscribe to the idea that maximizing time in the market is a more reliable strategy than timing the market, especially as it relates to income-first investing. That said, the key levers for generating alpha are asset allocation and security selection, and we can take a tactical approach to both.
We actively search for areas that we view as offering relative value — relative to their peers, relative to other industries or sectors, and relative to their own historical metrics.
Rampant pessimism is generally present in the worst of times, just as optimism or euphoria comes at the best of times. We would not attempt to call market tops or bottoms, but we can take note of areas that seem to be heavily weighed down by pessimism or propped up by enthusiasm. The same holds true for closed-end funds.
Going back to 1997, the universe of closed-end funds has traded at an average discount of -4.4%, but with notably wide dispersion. The late ‘90s bull market bid up funds as high as a 4.54% premium, while the great financial crisis in 2008 discounted values to a shocking -24.49% (on average) below NAV!
To be sure, both scenarios were the extreme. But to solidify the point, the late ‘90s and 2008 coincided with some of the most extreme highs and lows respectively of investor sentiment.
We would again reiterate that the bulk of returns in closed-end funds comes from income distributions and we think this should be the primary consideration. But considering the extremes we just mentioned, certain environments clearly present better opportunities than others to generate alpha.
Are those opportunities present today?
According to Morningstar data, as of 10/23/23 the average discount to NAV for closed-end funds stands at -11.25%. More than 2.5x the historical average discount of -4.4%.
|
|
All |
U.S. Equity |
Fixed Income Taxable Closed-End Funds |
Municipal |
|
Current Discount |
-11.258 |
-10.943 |
-8.925 |
-13.359 |
|
1yr Average |
-7.355 |
-7.434 |
-5.675 |
-8.521 |
|
3yr Average |
-5.709 |
-7.625 |
-3.763 |
-5.421 |
|
5yr Average |
-5.413 |
-7.249 |
-3.800 |
-5.810 |
|
10yr Average |
-4.630 |
-7.070 |
-3.305 |
-4.363 |
|
Long-Term Average |
-4.412 |
-7.238 |
-3.434 |
-4.008 |
Source: Morningstar as of 10/23/23 | Past performance is not indicative of future results.
It would certainly make our lives easier if there was a simple “thumbs up” or “thumbs down” emoji. Unfortunately, no such indicator exists. There is no magical discount or premium level that screams “BUY!” or “SELL!” with precision. We can only consider the information at hand to determine if we’re getting what we believe is a good value, and that is usually evaluated on a relative basis. The good news for us is that closed-end funds are one of the few vehicles with which we can attempt to quantify perceived value via the premium/discount relative to NAV.
As with any investment, there is no guarantee. There is little precision in predicting near-term stock returns, interest rates, or the forces of investor psychology. What we can do is make an educated assessment of relative value using history as our guide. Closed-end funds, at times, have the potential to offer attractive income. If we are presented with high levels of income, and prices at deeper-than-normal discounts, you might view that as relative value.
Investors considering closed end funds could start with a few fundamental questions:
- Is the fund's strategy consistent with my goals and complementary to my portfolio?
- Is the level of income attractive and sustainable?
- Am I purchasing at a discount that adequately compensates me for the risk?
Related: Beyond Investment Advice: The Vital Role of Advisors in Safeguarding Clients’ Total Wealth