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  My CEF Final Four
Posted Under: Yield • Discounts • CEFs

There are many different ways to approach investing in closed-end funds (CEFs) in the secondary market. One question I often get is "What factors do you think an investor should consider before investing in a CEF?" While there is no right or wrong answer to this question, from my standpoint the four most important criteria an investor should consider are discussed below.

  • Attractiveness of the underlying asset class: Just like an open-end fund (commonly known as a mutual fund) a closed-end fund can provide investors with professional management, diversification and exposure to many different asset classes depending on the objective of the fund. However, unlike an open-end fund where an investor buys and sells shares in the fund at net asset value (NAV) once a day after the market closes, closed-end fund investors purchase common shares of a fund on an exchange such as the NYSE throughout the trading day. These common shares are traded independently of the underlying NAV of the fund. While a closed-end fund's common shares trade on an exchange and independent from the underlying NAV of the fund, ultimately over time share prices usually tend to gravitate toward the underlying NAV of the fund. Therefore, from my standpoint, the attractiveness of the asset class the fund is invested in is extremely important in determining how the common shares will trade. This is precisely the reason I have had the highest conviction level in domestic equity CEFs and senior loan CEFs for the past two years as I have believed, and continue to believe, the fundamentals and valuations of both of these asset classes remain compelling.
  • Valuation: The price an investor pays for any security should always be one of the most important criteria they consider when deciding to invest and a closed-end fund is no different.  As it relates to the CEF structure, I think investors should focus on the share price of a fund relative to the fund's NAV. From my standpoint, investing in a CEF simply because the price is at a discount to its NAV is not all investors should consider. Rather, I prefer to focus on funds which are not only trading at a discount to NAV but also at a discount to NAV which is wider than the fund's historical average. When a fund trades at a discount to NAV which is wider than its historical average, it could be an indication that there is real value in a fund and the market has yet to appreciate that value. The website CEFA.com provides historical discount to NAV or premium to NAV information for CEFs.
  • Sustainability of the distribution: Considering the fact that many CEFs have the goal of distributing current income as their primary investment objective and considering the fact that many investors choose to invest in CEFs because of the compelling distributions they historically provide, the sustainability of a CEF's distribution is another key criterion on which investors should focus. A CEF is required to publically file its earnings rate per share data with the Securities and Exchange Commission (SEC) two times a year. Investors can compare this data with a fund's current distribution to get a sense if the distribution is likely to be maintained, decreased or increased. The website Cefconnect.com is another useful resource for this information. While the sustainability of a fund's distribution is one of the four most important criteria I think CEF investors should consider, it is important to note that owing to the floating rate nature of the interest on senior loans, distributions can be somewhat volatile from month to month for senior loan CEFs. Presently, given the attractiveness I see in the senior loan asset class, wider than average discounts to NAV available in many senior loan CEFs as well as the limited duration risk of the senior loan asset class, I am willing to accept some fluctuation in the distributions of senior loan CEFs.
  • NAV track record: The best way to judge how a portfolio manager or portfolio management team is doing in managing the assets they have been entrusted with is to analyze a fund's net asset value performance relative to its peer group and benchmark. Bear in mind roughly 70% of all CEFs employ the use of leverage and most benchmarks CEFs compare themselves to are unleveraged. Leverage enhances NAV performance in an up market but detracts from NAV performance in a down market. The website Morningstar.com provides detailed NAV performance data for CEFs as does CEFA.com and Cefconnect.com. I prefer to focus on CEFs where the portfolio manager has consistently delivered NAV performance in roughly the top third of his or her peer group for as long as they have been managing the fund. The reason the NAV performance of a CEF is an important criterion investors should consider before investing in a CEF is because, as I stated above, over time the share price of a CEF tends to gravitate towards a fund's underlying NAV.

While there are other factors CEF investors should consider before investing in a CEF including leverage structure, composition of a fund's distribution, average daily volume, etc., ultimately I believe the four factors discussed above are the most important and therefore makeup my "CEF Final Four."

Closed-end funds are subject to various risks, including management's ability to meet the fund's investment objective, and to manage the fund's portfolio when the underlying securities are redeemed or sold, during periods of market turmoil and as investors' perceptions regarding the funds or their underlying investments change. Unlike open-end funds, which trade at prices based on a current determination of the fund's net asset value, closed-end funds frequently trade at a discount to their net asset value in the secondary market. Certain closed-end funds may employ the use of leverage which increases the volatility of such funds.

All opinions expressed constitute judgments as of the date of release, and are subject to change without notice. There can be no assurance forecasts will be achieved. The information is taken from sources that we believe to be reliable but we do not guarantee its accuracy or completeness.

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Posted on Tuesday, November 12, 2013 @ 12:45 PM • Post Link Share: 
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These posts were prepared by First Trust Advisors L. P., and reflect the current opinion of the authors. They are based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
 PREVIOUS POSTS
Modest Improvement in Many CEF Categories; Potential for Tax-loss Selling
Domestic Equity CEFs Still a Favored Category
Still out of Favor but with Compelling Yields and Valuations
Share Prices Historically Track NAVs
Senior Loan, Limited-Duration and High Yield CEFs
Discounts to NAV Indicate Real Value
Update on Municipal Closed-End Funds
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