CEF 101: Don’t Buy Funds At Abnormal Premiums

CEF 101: Don’t Buy Funds At Abnormal Premiums

Investors in closed-end funds have to contend with different risks and analysis criteria than ETF or open-ended mutual funds.  Those that have spent any length of time in this space have more than likely learned how important it is to look beyond distribution yield, recent price trend, or the touch of a star fund manager.  While these characteristics are important, they can easily be overridden by an exorbitant premium or fundamental catalyst that turns the corner.

A recent example of this phenomenon comes in the form of the popular Doubleline Opportunistic Credit (DBL).  This fund was the first closed-end vehicle to be released by Jeffrey Gundlach at DoubleLine Capital in 2012.  It has thrived under the stewardship of his investment committee, posting average annualized market price returns of +12.00% from inception through 8/31/16.

The strategy is essentially a leveraged off shoot of Gundlach’s other flagship fixed-income strategies.  It carries a high degree of mortgage-backed security exposure with flexibility in risk management and/or sector positioning.

As you can see on the 1-year chart below, the share price of DBL really started to shoot higher versus its underlying net asset value (NAV) near the end of 2015.  This peaked with a premium of greater than 17% in September 2016 despite the fact that the NAV has essentially traveled a sideways path.

dbl_nav*Source: Morningstar.com

More recently, the uptick in interest rates, combined with the flighty nature of closed-end fund investors, caused a sharp correction in DBL’s market price.  The fund is now trading at just a 5.41% premium to its NAV as of October 13 (according to Morningstar data).  That 12% decline in market value came with little fluctuation of the underlying portfolio holdings.

Furthermore, investors who were aggressively purchasing DBL throughout 2016 should have been aware that this rising premium was somewhat of an abnormality.  The 3-year average premium for this fund is listed at +4.88% and it has even traded at a discount several times between 2013 and 2015.  This skewed risk profile should have set off alarm bells for those who were paying attention to these relative valuation metrics.

The lesson here is that loading up on a leveraged fixed-income portfolio trading at a significant gap above its historical average is a risky proposition at best.  There are some closed-end funds that trade at persistent premiums all their life.  However, it’s easy to identify these outliers and potentially justify their existence though some simple analysis at a free website such as Morningstar or CEFConnect.com.  All other funds that appear to be temporarily stretched relative to historical norms should be viewed with skepticism and caution.

We have owned DBL for clients in our Dynamic CEF Income Portfolio at various times over the years and ultimately believe it will work its way back into our holdings in the future.  However, we were net sellers of this position in late 2015 and mid-2016 as the premium started to significantly increase.  This type of fundamental examination is part of our ongoing due diligence and comparative research process to identify overvalued areas of the market.

Conversely, the same style of analysis can be used in reverse to detect funds showing strong relative value below their historical averages.  Periods of stress in the credit or interest rate markets can ultimately lead to closed-end funds trading at meaningful discounts.  Those are often the best times to strike.

 

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