Buy stocks for 90 cents on the dollar
IF you don’t believe in the efficient market hypothesis (the assumption that the market is essentially always correctly priced with all information factored in) you may be able to uncover some anomalies. One such anomaly that exists is the pricing of closed-end funds.
Closed-end funds are really the earliest form of mutual funds. They are essentially a fund that holds a collection of stocks, bonds or other securities. The difference between these funds and a mutual fund is that closed-end funds issue a set number of shares and trade on public exchanges. The key factor that makes them somewhat of an anomaly is that they tend to trade at a premium or discount to value of their underlying holdings. In essence the sum of their parts is often out of sorts with the price the market is quoting them at. Here is where the opportunity lies.
Let’s walk through an example (not an investment recommendation). The Eaton Vance Tax-Managed Global Fund trades under the ticker EXG. From the chart (pictured) we can see that the fund currently is trading at a 13.3 percent discount.
The last price traded here was for $9.05 but the value of the net assets in the fund is $10.44. In theory the fund could be liquidated and holders of the units would receive an instant profit of $1.39.
There are many plausible reasons why closed-end funds sell at discounts. It is reasonable to assume that if a large volume of stocks where suddenly dumped on the market it could result in lower prices, thus a simple liquidation would not necessarily realise the full quoted value. Other explanations suggest that liquidation is not likely to happen soon, so the waiting time for the discount to narrow could be years away and a lot can happen between now and then. Discounts could also reflect the market’s lack of faith in the manager’s skills and fund strategy, or illiquidity of the issue.
If you are evaluating whether the discount is warranted, it is important to consider a number of fund specific factors. One explanation for the large discount noted above for EXG could be attributed to its strategy, for example. The fund essentially generates extra income by selling covered calls on its underlying holdings. When volatility falls, call selling will yield much less income and the market may be anticipating a cut in the fund’s rather generous 10.8 percent indicated yield. After reviewing multiple factors and understanding potential reasons for a markdown some funds may actually allow you to buy stocks or bonds at an attractive discount.
A bigger mystery may be why some people buy closed-end funds at a premium. In these cases the market is likely anticipating the manager to have some exceptional performance or use embedded leverage in a positive way. In general, it is not a good idea to buy these funds at a premium. If you do own some premium priced funds, it’s likely best to sell them.
When you are assessing the merits of a discount or premium a good factor to note is the five-year historic premium/discount of the fund. If the discount, for example, is much more than the average over this time period it may offer an opportunity. In EXG’s case the five-year average discount to NAV is 7.5 percent versus its current 13.3 percent which would warrant further investigation into this potential opportunity.
Here is a list of three closed-end funds with sizable assets and discounts lower than their five-year average that you can do some further homework on:
Eaton Vance Tax-Managed Global Fund (Ticker: EXG)
Alliance Bernstein Income Fund (Ticker: ACG)
Royce Value Trust (Ticker: RVT)
Disclaimer: This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed may change as subsequent conditions vary. The information and opinions contained in this material are derived from proprietary and nonproprietary sources deemed by Anchor Investment Management Ltd. to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. Past performance is no guarantee of future results. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this material is at the sole discretion of the reader. Investment involves risks. Readers should consult their financial advisors prior to any investment decision.
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