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2 CEF Mistakes to Avoid

Investors need to take caution with public offerings and monitor CEF pricing inefficiencies, says ETFInvestor editor Sam Lee.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Sam Lee. He is an ETF strategist and also the editor of Morningstar ETFInvestor. We are going to talk about two big mistakes that many closed-end fund investors make.

Sam, thanks for joining me.

Sam Lee: Good to be here.

Glaser: Let's start with the first mistake that you see from a lot of CEF investors, particularly those getting started, what is that?

Lee: It's very simple. It's buying closed-end funds during the IPO. There is absolutely no reason to do that because the IPO process requires a lot of underwriters to get the whole process going and they need salesmen. They compensate these people by building in a commission that comes right out of IPO investors' capital. [When a closed-end fund has an IPO] it usually trades at around 5% premium to its net asset value. And that premium usually disappears within a couple of months.

The reason why it doesn't disappear immediately is because the underwriters will actually artificially support the market price of a closed-end fund to give the illusion that things are OK. And then a couple of months later they withdraw, and that premium usually collapses to a discount. IPO investors usually suffer somewhere around a 10% loss within just the first few months of investing.

Glaser: Are there ever any situations when investing at the IPO makes sense?

Lee: Very rarely. One is if it's a very in-demand IPO and you think that the premium is going to go up even more. So this is arguably the case with certain closed-end funds from PIMCO and maybe DoubleLine. There are certain marquee managers where it might be reasonable to invest in the IPO. But in most cases I would say it's not the smart move.

Glaser: What's the other big mistake that you see investors making out there?

Lee: And this is surprisingly common, and it's related. It's buying closed-end funds at a massive premium. Double-digit premiums and above are almost never defensible in terms of a value perspective. Most closed-end funds don't offer a unique exposure that you can't get somewhere else, either through a different closed-end fund that's trading at a discount or at lower price or through an ETF or a mutual fund. It's very, very rare for a closed-end fund to actually deserve a high premium.

And one good example, the closed-end fund with the highest premium right now is PIMCO High Income, ticker PHK. It's trading at a 50% premium to net asset value. The reason why it trades at such a high level is because it has a very high distribution yield. The funny thing is closed-end fund investors think that it doesn't matter too much what the premium or the discount is, as long as the distribution yield is good or not. Is it high or is it low?

But in this case this distribution yield is actually not as high as it seems because a lot of it is return of capital. And not only that, but you can actually get a very similar strategy, a near-identical strategy, at a lower price. PIMCO Corporate Income & Opportunity, ticker PTY, has almost the same exact strategy as PHK, except it's a slightly less leveraged version of it. So it doesn't have as high of a distribution yield.

But this one unfortunately also trades at a 20% premium to net asset value. But I think this is a clear example of a market inefficiency, where you have basically two identical strategies. One is slightly more leveraged than the other. One simply distributes more of its assets every year than the other. And the one that has the higher distribution yield has a much higher premium, even though economically these are two very similar strategies, near substitutes.

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Glaser: But how can you really tell then when a premium or discount is reasonable? We have talked in the past about how just the existence of a discount doesn't mean it's a bargain and just because there is a premium doesn't mean that it's a bad investment. How do you really asses this then other than just that rule of thumb?

Lee: One good rule of thumb I feel that distinguishes a rational from an irrational discount or premium is how constant that spread is through time. If a discount seems to have lasted for many, many years and hasn't changed very much, through bull markets and bear markets that spreads tends to stay fairly constant, that suggests that the market has assigned a fair discount to that asset, and so that discount doesn't move around very much.

An irrational one tends to be a lot more volatile because investors reacting to news will push around the prices for no good reason. One good example is for, again PHK, and [PIMCO Global StocksPLUS & Income] ticker PGP, another very high premium closed-end fund, Barron's wrote an article about how these premiums were dangerous. And [the article] didn't really say anything other than that these premiums are dangerous; these are two funds with very high premiums. And once that article came out, the premiums collapsed. So these funds collapsed 10%-20% within a matter of days after that article came out. And that's a pretty clear example of an irrational premium. Any volatile spread, I think, is a very good indicator it's irrational.

Glaser: So double-digits could be a red flag, but make sure to look at that historical data, too?

Lee: Yes.

Glaser: Well Sam, I appreciate your thoughts today.

Lee: Good to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.

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Samuel Lee does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.