CEF Discounts and Premiums

(information from Morningstar.com’s CEF section)

CEFs have an underlying portfolio of securities. From this portfolio, a net asset value (NAV) can be derived.

NAV = (assets – liabilities) / shares outstanding

the investment portfolio primarily, if not solely, comprises the assets. For leveraged CEFs, the leverage itself is the bulk of the liabilities.

CEFs trade on an exchange. This means that they have a share price, which is set by the market. These two prices, the NAV and the share price, are rarely the same, and when they are, it's only by coincidence.

The differences between the share price and the NAV create discounts and premiums. Shares are said to trade at a "discount" when the share price is lower than the NAV.  The discount is commonly denoted with a minus ("-") sign. Shares are said to trade at a "premium" when the share price is higher than the NAV. The premium is commonly denoted with a plus ("+") sign. The calculation is (Share price ÷ NAV) – 1. Examples:

Share price = $19.00

NAV = $20.00

Discount = ($19.00 ÷ $20.00) – 1 = 0.95 – 1 = -0.05 = -5.0%

Share price = $12.00

NAV = $10.00

Premium = ($12.00 ÷ $10.00) – 1 = 1.20 – 1 = +0.20 = +20.0%

What gives rise to discounts and premiums? Why is the market seemingly inefficient?

Efficient market hypothesists have tried to explain discounts and premiums for years with myriad explanations. Most commonly, the reason a CEF trades at any given discount or premium is related to the fund's distribution rate, regardless of the source of the distribution. (Some fund families seemingly abuse the knowledge that this occurs to justify--in their minds, not ours--the use of destructive return of capital.)

Other typical reasons for premiums and discounts include:

• Overall market volatility
• Recent NAV and share price performance
• Brand recognition of fund family
• Name recognition (or lack thereof) of the fund manager
• Recent changes in distribution policy
• An asset class or investment strategy falling out of market favor
• An asset class or investment strategy rising in the market's esteem

Whatever the reason for a CEF's discount or premium pricing, it is crucial that CEF investors realize that discounts and premiums exist.

At Morningstar, when comparing a share price with a NAV, we often refer to discounts and premiums as "Absolute Discounts" and "Absolute Premiums."

We do this because, as discussed in another Solution Center presentation, there are other ways to look at discounts and premiums. For instance, if we compare a CEF's discount to its average historic discount, this is what we refer to as a "Relative Discount."

Most long-term investors just look at Absolute Discounts and Absolute Premiums. But when considering valuation, it's important to look at Relative Discounts and Relative Premiums.

There are three things to consider regarding discounts and premiums:

1. Regardless of the discount or premium, what matters to an investor is the share price at the time of purchase and the subsequent total return of the CEF.
2. A CEF's discount or premium tends to persist. If the CEF typically trades at a large discount, it will tend to stay at a large discount, barring any corporate actions from the board of directors. The same can be said of premiums. Even in periods of extreme market volatility, CEFs that typically trade far below or far above the universe's average discount will more than likely continue to trade that way, even if during the downturn the premium turns to a discount.
3. Over a complete market cycle, most CEF share prices will trade below, at, and above their corresponding NAVs.

Absolute Discounts

The standard thinking for CEFs is to focus on funds trading at discounts and to avoid funds trading at premiums. We think this maxim is simplistic and could lead to unrealistic expectations for investors.

All that matters for a CEF investor is the share price at which the CEF was purchased and the subsequent total return. Discounts and premiums wax and wane over time. For instance, if a CEF is trading at a 15% discount, people often tout this as an opportunity to buy $1.00 of assets for $0.85. The unstated premise is that eventually the price will reach $1.00.

This is problematic. Nothing mandates that a share price, even discounted at 15% to NAV, must converge to its NAV over time. Furthermore, the NAV could decline to $0.85 (or lower).

We recommend not purchasing CEFs at absolute discounts in the hope that the share price will converge to a higher NAV. The primary benefit of purchasing a CEF at an absolute discount is for income-seeking investors to enhance their yield.

"Yield Enhancement" and Absolute Discounts

Putting aside sources of distribution, let's assume that a fund's underlying portfolio at NAV yields 10%.

Distribution = $1.00 per share

Net Asset Value = $10.00 per share

Distribution Rate at Net Asset Value = $1.00 / $10.00 = 10%.

Let's further assume that the shares trade at a 10% absolute discount.

Net Asset Value = $10.00 per share

Share Price = $9.00 per share

Absolute Discount = (share price – NAV)/NAV = ($9 - $10) / $10 = -10%

Because they are buying at a discount, investors purchasing these shares will get a higher yield:

Distribution = $1.00 per share

Share Price = $9.00 per share

Distribution Rate at Share Price = $1.00 / $9.00 = 11.1%

So, "Yield Enhancement" = Dist Rate (Share Price) / Dist Rate (NAV) = 11.1% / 10% = 1.1%

Buying $1.00 of assets for $0.85 isn't necessarily a bargain.

The table below sets forth the nine scenarios that can play out when purchasing shares at an absolute discount.

How the Absolute Discount Can Narrow

1. NAV falls faster than the share price: This is the worst possible scenario. The underlying portfolio is losing value and your shares are worth less.
2. NAV falls and share price remains steady: This is the second-worst scenario, in that the underlying portfolio is losing value. At least your shares haven't declined in value.
3. NAV falls and share price rises: The investment portfolio is heading south but at least you are making some money. Be careful, though, because ultimately the discount or premium will rely, at least in part, on the portfolio's performance.
4. NAV is steady and share price rises: This is the scenario implied by investors who say they buy $1.00 for $0.85.
5. NAV rises and share price rises even faster: This is the best of all possible scenarios. Of the nine scenarios, this occurs in only half of one (because the NAV could rise faster than an increasing share price, meaning the discount would widen).

Also note the several scenarios where the share price declines or the absolute discount widens. Using absolute discounts as the sole method of finding undervalued CEFs is akin to investing in a value trap.

On the flip side, there is no reason to avoid all CEFs trading at an absolute premium.

If you are purchasing shares at an absolute premium, you are taking on risk. Your capital could decline, even if the underlying portfolio performs well.

This isn't to say you should never invest at a premium. Most CEF investors have no qualms investing at slight premiums to NAV. But absolute premiums above 10% should really give you pause.

The table below shows the nine scenarios that can play out when purchasing shares at an absolute premium.

If you find yourself in a situation where the share price is rising and the NAV is declining, you are likely in what Warren Buffett might call a "greater fool" scenario. You may want to consider taking your profits and finding a more suitable investment.

Note that only one half of one scenario leads to a rising share price and a narrowing premium.

Unwittingly purchasing shares at an absolute premium, only to see the share price decline as the premium narrows, is the number one reason people have a poor experience with CEF investing.

Key Takeaways

• Every CEF has a discount or a premium. It is rare, and short-lived, for a share price to equal the net asset value.
• Absolute discounts are an inappropriate method of finding undervalued CEFs. When searching for undervalued CEFs, use relative discounts
• Absolute discounts can and should be sought for "yield enhancement." Make sure to see our Solution Center presentation on distributions.
• Absolute premiums should not preclude investment, but they do represent additional investment risk. Extreme premiums above 10% should really give investors pause. Unless the NAV rises to meet your purchase price, even in the long run you will likely lose money on your investment.
• While there is nothing that mandates a CEF share price equal its net asset value, history shows that funds normally trade at both an absolute discount and an absolute premium over the course of a full market cycle. In other words, the share price does tend to revert toward, and then through, the NAV.
• Again, when investing in CEFs, discounts and premiums don't ultimately matter. What matters is your cost basis and the subsequent total return.

Understanding Leverage in a CEF

What Is Leverage?

Leverage simply means that an investment portfolio is larger than its net asset base. The fund raises additional capital through a debt issuance, a preferred share issuance, or by using sophisticated financial products to increase the value of its underlying portfolio.

Say, for example, a fund has net assets of $500 million, raised in an initial public offering of 50 million common shares.

• It then issues $250 million of preferred shares.
• Total capital is then $750 million.
• Common shares outstanding are 50 million.
• Total capital per share is $15.00
• Net asset value per share = (Total Capital - Liabilities (preferred shares)) ÷ Shares Outstanding = ($750 million - $250 million) ÷ 50 million = $500 million ÷ 50 million = $10.00

This CEF has a leverage ratio of 50%, computed as capital from preferred shares divided by net asset value: $5 from preferred shares ÷ $10 in net asset value = 50%

Leverage magnifies returns, both positively and negatively. In other words, a leveraged fund exhibits more volatility than would an unleveraged fund investing in the same securities.

Why Can CEFs Use Leverage?

Because of their closed-end structure, CEFs are allowed by law to use leverage. Specifically, according to the Investment Company Act of 1940--which provides the framework for CEFs, mutual funds, and ETFs--CEFs are allowed to issue:

• Debt in an amount up to 50% of net assets
• Preferred shares in an amount up to 100% of net assets

In practice, the average leveraged CEF carries 33% total leverage. For every $1.00 of net assets, they have another $0.33 in leveraged capital.

Non-'40 Act Leverage

Leverage achieved through debt and preferred shares is commonly referred to as "'40 Act Leverage," after the Investment Company Act of 1940. There are other methods by which a fund can leverage its net assets. This is referred to as "Non-'40 Act Leverage."

Whereas the provisions for leverage within the '40 Act were meant to safeguard the integrity of a fund's capital structure, non-'40 Act leverage is unrelated to the capital structure. It arises, instead, from the fund's portfolio of investments. Examples of non-'40 Act leverage include:

• Tender option bonds
• Reverse repurchase agreements
• Securities lending obligations

Transparency

Leverage is leverage. Regardless of the source of the leverage, it has the same effects on a portfolio as outlined earlier in this presentation. This is why transparency of a fund's true leverage is so important.

Only '40 Act leverage is required by law to be reported. All leverage is actually reported on the financial statements, but only '40 Act leverage needs to be reported as "leverage."

Fund families have wide discretion in how they choose to actively report non-'40 Act leverage. Their websites may say a fund is unleveraged, when it actually has a lot of non-'40 Act leverage.

One simple way for investors to check leverage ratios is the following:

Total Leverage = Total Assets / Net Assets

The closer the value is to 1, the lower the leverage.

Morningstar.com shows a CEF's '40 Act leverage, non-'40 Act leverage, and total leverage ratios to help investors see what's really going on.

Key Takeaways

• Adding leverage to a CEF's portfolio will increase volatility of NAV returns.
• Adding leverage can also enhance a CEF's distribution rate.
• There are costs to adding leverage to a portfolio.
• While the Investment Company Act of 1940 allows CEFs to issue debt and preferred shares (with certain limitations), CEFs can also use non-'40 Act leverage.
• Regardless of the source of the leverage, the effects will be the same.
• In times of extreme market distress, a leveraged fund may be forced to liquidate holdings to meet leverage coverage ratios. In such rare cases, the benefits of the closed-end structure eviscerate, and the capital is permanently impaired. In 2008 and 2009, this happened to a few leveraged high-yield ("junk bond") CEFs.
• While many investors are rightfully cautious about leverage, it's important to understand that the average leveraged CEF is only 33% leveraged.

I will be adding a rule to my CEF watch list to exclude CEF’s that are 30% or more leveraged.

A Look at Closed End Funds (CEF’s)

(information obtained from cefconnect.com)

Currently my portfolio is out of balance due to selling some positions in profit during a high level of the S&P and expecting a pull back soon.  So my dividend portion of my portfolio is out of balance.  I am looking to have cash available to enter new positions during the next pullback.  I am reviewing my study of closed end funds because I want to enter a few positions in my income allocation to increase the yield without adding undue risk.

What is a Closed-End Fund?

A closed-end fund is a publicly traded investment company that invests in a variety of securities, such as stocks and bonds. According to the fund's investment objectives, the fund raises capital primarily through an initial public offering (IPO). "Closed" refers to the fact that, once the capital is raised, there are typically no more shares available from the fund sponsor and the issuance of new shares is closed to investors.

After the IPO, most closed-end funds are listed on a national exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. There the fund's shares are purchased and sold in transactions with other investors, not with the sponsor company itself.

The typical closed-end fund strategy represents an actively managed selection of holdings. These investments in securities collectively add up to a value, known as its Net Asset Value (NAV), that may be different from the fund's market price. The market price is determined by market demand and supply, not the fund's net asset value.

Since most closed-end funds offer regular monthly or quarterly distributions, demand is often related to both the distribution amount and the NAV performance of a fund.

Although the outstanding shares of a closed-end fund remain relatively constant, additional shares can be created through secondary offerings, rights offerings or the issuance of shares for dividend reinvestment.

Key Considerations for Closed-End Funds

Closed-end funds are investments designed for income-conscious investors seeking to meet a wide range of investment goals, including:

• The potential to meet current obligations with monthly or quarterly cash flow;
• The potential to achieve attractive, long-term total returns;
• The opportunity to realize greater income portfolio diversification.

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Closed-end fund shares also carry risks investors should understand:

• Closed-end funds trade on exchanges at prices that may be more or less than their NAVs.
• There is no guarantee that an investor can sell shares at a price greater than or equal to the purchase price.
• Closed-end funds often use leverage, which increases a fund's risk or volatility.

There are several characteristics of closed-end funds that can help investors meet their investment goals:

Portfolio Management - The asset base for closed-end funds is relatively stable. Without the pressure of constantly investing or redeeming securities based on investor demands, closed-end funds may be able to take better advantage of a wide variety of investment strategies, including longer-term and less liquid securities or markets.

Distributions - Closed-end funds are generally designed for regular cash flow. Distributions are paid according to a prescribed schedule -- typically monthly or quarterly -- which allows investors to plan the timing of this income. Of course, the actual amount of the distributions may vary with fund performance and market conditions.

Leverage - Closed-end funds often borrow capital or issue preferred shares in order to leverage their portfolios. The goal is to use the additional capital to invest for a return that exceeds the cost of the leverage. Any excess return, or loss, is added to the return on capital raised through common shares. Thus, leverage multiplies both potential return and the volatility of the fund's portfolio. .

Market Pricing - Investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of closed-end funds.

Trading Liquidity and Flexibility - A stock market listing means that closed-end fund shares may be bought or sold at any time during the trading day, and the price is updated throughout the trading day, not just at the close. Like other investments, share prices will fluctuate with the market, and may be worth more or less at the time of sale than the original purchase price.

Expenses - Closed-end funds typically do not impose annual 12b-1 fees. However, investors must still pay a brokerage commission to purchase and sell shares for all closed-end funds. For those investors who trade frequently, this can significantly increase the cost of investing in closed-end funds. This means closed-end funds may have lower expenses internally, but an investor's total costs may not be lower.

I intend to add a series of posts as I review what I am looking at to analyze the funds and make selections.

Manage Risk with Position Sizing

Position sizing should be part of your overall investment strategy regardless of what style of investing you use.  It is intended to control downside risk.  There are certain rules you should follow but like most things with stock investing you do have to customize the process to fit your personal needs and risk profile..

How much you buy in a single trade—or your position size—is a critical decision. It directly impacts how much you might gain or lose on a trade and is another key part of the risk equation. Position size is influenced by two important concepts: portfolio risk and total amount invested.

Portfolio risk is the target maximum amount of money you’d lose on a single trade if the trade hit your stop, or was “stopped out.”  Most investors with a “Low” appetite for risk should settle in on .5%, moderate risk 1% and aggressive should keep it 2% or less.  If you are just getting started with investing I’d recommend the 1/2 percent level until you get familiar with how the sizing works and impacts your overall portfolio.

Investors also need to consider the total amount invested in any one trade. Consider setting a guideline to allocate no more than 10% of your portfolio to one investment. You may want to scale down if you’re more conservative or new to investing.

To figure this all out you need to determine the Trade Risk of the stock you are ready to purchase.  Trade risk is the stocks purchase price minus the stop price.

Stop Price has no right or wrong answer when calculating.  It is your decision to make at the time of the purchase when you get out of a stock that is turning against you.  One good method is to look at current support levels on the chart and set a stop price.  (Low risk appetite set just below support, average risk about 3% below that and more aggressive set about 5% below support. 

Here’s an example of a stock XYZ selling for 55.69. 

Some might see support at 53 while others may call support at 50.50.  Neither is wrong and will end up carrying the same risk in dollars.  The trade risk on the 53 stop is 55.69-53=2.69  while the trade risk on the 50.50 stop is 55.69-50.50=5.19

In the below example, notice that the acceptable risk per transaction is 1000 dollars so with the tighter stop you can purchase 371 shares but need to get out if stock goes down to 53.  Also notice that since you don’t want to exceed 10 percent of the portfolio you need to reduce your purchase from 371 down to 179 to stay under 10,000 dollars.  This also reduces your risk exposure down to 481 dollars if you have to exit at 53.

Higher trade risk below equals less shares per max risk (192 vs 371 above) but shares to actually buy remains the same at 179 due to 10% allocation rule.

Lastly, Here is a google spreadsheet for you to use to make your own calculations if you decide you like this concept and want to incorporate it into your trading rules.

Google Sheets Position Sizing Calculator

I did put edit rights on this share but if you plan to use it you should save a copy of it to your google sheets for your personal use.

A Look at Stock Rover

Alex Reisman of Stock Rover gives an overview of the online stock research platform.

At a glance:

• Online stock research software
• Screening, stock comparison & portfolio analysis
• Link to brokerage for automatic portfolio syncing
• Free & paid membership plans

Stock Rover is an interactive “dashboard” where you can engage in robust stock research. Stock Rover’s goal is to help individual investors make informed, independent decisions and to support them in their investing goals.

There are two membership levels: Basic (free) and Premium ($249.99/year or $74.99/quarter). Both levels provide detailed data on North American tickers, using the same integrated, comparison-oriented format. The major advantages that Premium offers over Basic are more financial metrics, 10 years of historical data rather than five, data export to offline CSV files, more flexible screening, deeper portfolio analysis, portfolio planning tools, and an ad-free environment. A 14-day free trial of Premium is available to all users (no payment information is needed; learn how to start the trial here).

Once you register for the FREE version and sign in you will go to a Summary page.  Look for an Orange button in the upper right corner of the page that says : “Launch SR” and click on that.  This will take you to the Stock Rover Basic application shown in the screen shot below.

The above screen shot is showing where the strong sectors of the overall S&P is right now.  You can sort by any of the columns.  Day traders want to see what's strong now.  Swing traders might want to see what’s strong over the past 5 days while trend traders or intermediate traders might look at the past month for strength.  Then you can drill down into the sectors to show what industries are strongest then drill into the industries for a list of stocks in that industry to see what particular companies are the strongest.  Once you select a company details of the stock show up using the tabs, side bar and comparisons highlighted in the screen shot below.

Good site well worth the time to register and learn how to use…

Why Starting Young with Long Term Strategy Pays Off

Stocks That Raise Their Dividends Greatly Outperform

Academic and industry studies confirm that quality dividend payouts lead to strong future returns. That’s a mouthful to be sure, but what it distills down to is that as an investor, dividends allow you to have your cake and eat it too! Dividends provide you with a valuable income stream, plus they can play an important role in helping you focus in on stocks that have the ability to produce staggering share price growth.

In order to appreciate the predictive power of dividends, consider a recent study conducted by Ned Davis Research and Oppenheimer Funds (see Figure 1 below).

The study looked at the average annualized returns for S&P 500 stocks from 1972 to 2014. As you can see, during this impressive 42-year study, stocks with Rising Dividends greatly outpaced the stocks that cut their dividends or simply did not offer a dividend in the first place. Further, if you focused on investing in Rising Dividend Stocks over fixed dividend stocks, you would have received 32% more return each and every year of the 42-year study.

(above is from AAII)

Barrons Review of iViewMarkets

Top Websites for Quantitative Stock Analysis

IVIEWMARKETS (iviewmarkets.com) is a similar market-analytics Website, but it focuses on data-gathering. It provides real-time market information and tools to rate the prospects of 10,000 U.S.-listed stocks and funds. But, instead of the proprietary factors used by Chaikin, iVIEWMarkets, a just-launched free site, employs off-the-shelf technical and fundamental measures. The company was started by Brett Golden, its president, who also founded the paid site ChartLabPRO (chartlabpro.com), which features its own proprietary tools.
Like Chaikin Analytics, the graphical nature of the site helps visitors follow its often-overwhelming data stream. Charts, heat maps, and gauges facilitate quick interpretation of popular internal market indicators and individual security metrics.
Complementary indicators are grouped together into views outfitted with just the tools and data appropriate to them. For example, the Trader View mixes the week’s best- and worst-performing Standard & Poor’s 500 members, overbought and oversold securities, and the relative performance of the week’s best industries.
These kinds of market triggers often find their way into trading algorithms. But iVIEWMarkets doesn’t offer the kind of algorithm-building platform found on social quant sites, such as Quantopian (quantopian.com). Its focus is to identify and deliver key market data—in real time.
During the recent market slaughter, iVIEWMarkets e-mails delivered changing support and resistance levels for all securities in subscriber portfolios daily. Chartists with a better-than-average knowledge of technical analysis can figure these out. But think of the time saved by having a dozen or more of these key entry and exit inputs recalculated for you every day.
Time is always of the essence. And for traders, not just any knowledge, but rather actionable information, is power.