The universe of closed-end funds, valued at $220 billion, is the scene of sometimes crazy prices, which include a good number of good purchases and a few really bad ones. There is a formula that will help you distinguish them
Discount! Fund on sale! Closed-end funds trading at a discount to their liquidation value seem like hot buys. A few are. Most are best avoided.
A closed-end investment company is a peculiar beast. Unlike funds that are open-ended or publicly traded, a closed-end fund has no mechanism to liquidate the holdings of departing clients. Their shares are listed on the second-hand market, with prices set by supply and demand, which can be far from their equity value.
A background sold with a “15% off” sticker is not the same as a discounted kitchen appliance. If you were willing to purchase the dishwasher at full price, a 15% markdown is money in the bank.
The same does not happen with a fund. Having a discount on it doesn’t leave you any better off unless something happens that turns the fund portfolio into cash for you. That could be a liquidation of the fund, a rare event, or a disbursement of the fund. It might seem like the discount alone would magnify your returns. It is not like this.
Let’s say a fund is trading at a 15% discount to its net assets. So for every $85 you invest, you have $100 going to work for you in the market . But that does not increase its profitability. If the fund portfolio doubles in value, every $100 you have in it goes up to $200, but you don’t come out $100 ahead. If the discount holds, your $85 increases to $170, and you get the same 100% return you would have if there was never a discount.
Sometimes fund discounts narrow. Sometimes they are expanded. A neutral assumption in your analysis is that the discount holds.
Most closed-end funds out there trade at discounts. Only a few are real bargains. They are the ones that combine a discount with two other things: cash distributions and reasonable expense ratios.
There is, in fact, a simple formula that relates three variables – discount, distribution rate and expense ratio – to tell you when a closed-end fund is worth taking a look at. This is what results when the formula is entered into a database of closed-end funds available on Ycharts , an online resource for investors. The screen counted only the 421 funds with at least $50 million in net assets.
How does this formula work? Let’s go back to our hypothetical fund valued at $100 per share, but available at a price of $85. Assume that the fund makes annual cash distributions equal to 10% of the value of the fund’s assets. Every $10 check you receive in the mail is something you bought for $8.50. So you have an instant profit of $1.50.
Let’s now assume that the fund has an annual overhead of 1%. That’s 1 dollar out of your pocket. But then there’s the $1.50 windfall that more than offsets the expenses. The annual holding cost of a share with a net asset value of $100 is negative 50 cents. Its effective expense ratio is -0.5%.
Here is the cost of holding formula : Add to the published expense ratio the product of the distribution yield and the discount or premium, treating a discount as a negative number and a premium as a positive one.
In the hypothetical example: 1% + 10% x -15% = -0.5% . A negative expense ratio, not found in any conventional mutual or exchange-traded fund, is a good deal. If the discount is not reduced or widened, your return on a fund with an effective expense ratio of -0.5% will be what the portfolio gives you plus an additional 0.5% per year.
Overpriced funds work the other way around, with distributions poisoning returns. If our hypothetical fund were trading at $115, the expense formula would be 1% + 10% x 15% = 1.5%. Your profitability would be what the portfolio provides you minus 1.5% per year. A bad business.
The remunerative impact of a cash payment on a discounted fund applies regardless of the source of that cash. It could constitute interest and dividends on the portfolio , or capital gains realized on the portfolio or simply a return of the shareholders’ own capital.
What does matter is whether the distributions continue, and that is sometimes difficult to predict. The cheap funds table includes those with a negative cost of ownership of 0.5% or better, based on recent distributions. In some cases, distributions are related to capital gains that cannot be counted on. In other cases – BlackRock ‘s technology fund , for example – performance reflects a policy of delivering a certain monthly payment, whether earned or not. The bottom three do not break the -0.5% barrier but are still negatively costed using a more conservative yield figure (not shown) equal to the average of the total distribution yield and the revenue-only yield.
An asterisk must go to two of the winners in the negative cost competition, namely the Highland funds . A large portion of their portfolios is invested in affiliated companies whose valuations require a leap of faith. They may or may not turn out to be bargains. Money managers who spend their days evaluating closed-end funds take into account many variables, such as volatility, trading volume, and the historical range of a fund’s discount or premium. One of these experts, Erik Herzfeld , is profiled in this article.
Investors unwilling to delve into such statistical depths need a simpler approach. Here, we adopt John Bogle’s principle that costs matter more than anything else. Thus, the tables do not assign any value to how a portfolio has performed in the past . This approach is justified by the fact that, apart from expenses, past performance has only a minimal relationship with future performance. Paying more for an attractive fund is, on average, just a way of paying more for an average return.
Let’s now use the cost effective formula to focus on the worst purchases. These are funds that combine high expenses, a share price above the net asset value and lavish distributions. A cash split from a high-priced fund is a form of dollar destruction. Here are five standouts in the high-cost derby.
Closing a fund erases a discount. It happens, on rare occasions. Goldman Sachs threw in the towel this summer on its MLP & Energy Renaissance Fund , generating a windfall for anyone who bought just before the liquidation was announced.
But it would be unwise to count on these types of events, which usually require the cooperation of the money manager who earns commissions from the fund. As farmers often say, it’s awfully hard to get a pig to butcher itself. Don’t stay in a fund with high expenses unless the payments, combined with the discount, offset those expenses.
