What if you could buy an investment that you know with certainty is priced less than its actual asset value? With closed-end funds (CEFs), investors can do so and can benefit greatly when both the underlying CEF portfolio performs well and the discount to the fund’s net asset value (NAV) gets reduced.
My firm has successfully generated excess returns in recent years by incorporating CEFs into well-diversified investment portfolios. The CEF investment process to which we adhere does not require exhaustive research and entails the following steps:
Step 1: Screening
My firm begins the CEF research process by screening the fund universe to narrow the list of potential candidates. An extremely useful (and free) website that facilitates this screening is etfconnect.com. This site enables users to screen CEFs by asset class and subclass. Furthermore, users can eliminate those funds not trading at a discount to NAV.
Once etfconnect has generated a candidate list based upon the selected screening criteria, the user can sort this list by various factors, including the percentage discount to NAV. My firm typically sorts by market capitalization because liquidity can be an issue when trading CEFs. With smaller bond CEFs, for instance, an investor purchasing as little as $10,000 worth of the fund can impact the market price. This liquidity factor likely explains why many institutions and hedge funds do not trade CEFs even though these investors are fully aware that various CEFs can be purchased at a discount to NAV.
Step 2: Fund Research
After screening and sorting the CEF selections, the etfconnect user can read detailed summaries of each fund that passed the initial screen. These summaries provide relevant details, including the characteristics of the securities within each fund and each fund’s expense ratio.
Once my firm evaluates the fund summaries and narrows the candidate list further, each fund’s prospectus is scrutinized. The prospectus, which can be accessed online at the fund company’s website, sheds much more light on important criteria, such as the fund’s investment approach and management team.
Step 3: Rankings
After reading through each prospectus, my firm ranks the CEF candidates by:
- The management team’s experience and track record.
- The expense ratio (lower is better)
- The discount to NAV (again, lower is better
It is also prudent to consider the degree of leverage the fund incorporates, as leverage can amplify returns. Those more risk-averse investors should avoid CEFs that use greater leverage.
Step 4: Placing the Trade
Once the rankings are used to make a final selection, the fund’s trading volume should be monitored closely before any purchases are made. Given potential liquidity issues with smaller CEFs, buyers should ensure that the prospective share-purchase volume is well within the fund’s average daily trading volume. Otherwise, the purchase price could end up notably higher, thus the goal of buying at a discount could fall by the wayside.
Those who follow the investment process and buy well-managed CEFs at a discount may experience investment results that are at a premium.
Jonathan Lederer is the President of Lederer Private Wealth Management, a Sacramento-based investment-advisory firm that provides the customized financial solutions the high net worth households. A CFA charter holder, Jonathan earned his MBA from the University of Michigan’s Ross School of Business and graduated with a BA from the University of California at Berkeley. He can be reached at 916-648-3059 or online at ledererpwm.com.
