By The Sick Economist
The concept of net asset value (“NAV”) in regards to CEF share price is also a critical bit of mechanics to understand. A solid understanding of this idea will power your portfolio to profit.
To review, the CEF is the vehicle, and the NAV are the passengers within the vehicle (the assets). Sometimes, the passengers within the vehicle are worth more than the vehicle itself, and sometimes the vehicle fetches more on the open market than the passengers alone would. When the shares of a CEF trade for less than the value of the NAV, then they are said to be trading at a discount. When the CEF shares trade for more than the NAV, then they are trading at a premium. The discrepancies between these two prices can turbo charge your profits.
Sometimes, there is a good reason why shares of a CEF might trade for less than the NAV. Maybe the whole sector is depressed and has attracted negative media attention (2020 was the annus horribilis for oil, for an example). Maybe the fund in particular has problems (accounting scandal, corporate takeover drama, etc). But very often, whole sectors simply fall out of fashion for very little reason. These are like the Z-Cavarrici pants lurking in the back of your closet. There is nothing wrong with them; they were fine garments when you originally bought them, and in fact, you could wear them today, if you could stand being mocked by your colleagues. (“Hey, the 90s called, they want their pants back!”). People that enjoy bargain hunting can find some real value in the CEF space by looking to buy funds that are trading at a discount to their NAV.
Let’s look at my investment in the Tekla World Healthcare Fund (Ticker: THW). When I bought this fund, it was trading at a discount to NAV of about 10%. The thinking was that Donald Trump was going to take a wrecking ball to the American pharmaceutical industry and that long threatened pricing reforms would greatly limit Big Pharma’s profits moving forward. I never believed in that theory, and I’m just a nerd for healthcare stocks, so I bought THW. At the time, the CEF was yielding in the range of 9%. So, for every $1,000 I invested, I could get an annual payout of $90 while I waited for the world to come to its senses on healthcare.
Guess what? They did. Big Pharma weathered the storm of hot air about pricing reform (as they always have) and then COVID-19 happened. All of a sudden, instead of being the boogieman of American capitalism, Big Pharma was viewed as the hero. In America’s time of need, they came running for help, and Big Pharma produced massive quantities of highly efficacious vaccines in record time. To return to the fashion analogy, suddenly those Z-Cavarrichis came roaring back into fashion, and you were the first guy at the party to rock that style. After all, you never threw them out to begin with. Today, Tekla World Healthcare Fund actually trades at a premium of about 3% to the NAV. So, not only have I collected a juicy 9% dividend every month for years, I have also enjoyed substantial price appreciation on my shares.
Am I some kind of investing genius? Not really. I just learned the rules of the road and learned to drive astutely. You can do the same.
Armed with knowledge, you are ready to hit the CEF highway. These funds typically pay between 4 and 10% monthly dividends, often on a tax advantaged basis. These strong, steady payouts can make a huge difference in your retirement income.
As we said earlier, there are thousands of different CEFs with as much variety as that crowded highway we have been talking about. There are few different ways that you can shop.
The first way is to choose a sector and work backwards. In my example, I have a particular interest in healthcare stocks; this led me to Tekla World Healthcare Fund. Maybe you like municipal bonds, or utility stocks, or even preferred shares. All of these are different kinds of passengers that can be stuffed into a CEF vehicle. The reason why you would buy them through a CEF as opposed to an exchange traded fund or directly would be because the CEF will provide higher yield. As stated earlier, Tekla World Healthcare often yields 8% or more, while the underlying stocks, if bought directly, would only yield between 2 and 4%.
Another example would be CEFs that invest in municipal bond funds. My elderly aunt loves to invest in municipal bonds. These are ultra safe bonds issued by state and local governments to pay for municipal projects, such as water and sewer. These bonds have been a staple of retirement planning for decades because they are very safe and offer tax free yield. However, in the last decade or so, “muni bonds,” as they are called, have offered less and less yield to the point that you would be lucky to collect 2% on your money. Now my aunt buys muni bonds through closed-end funds and she can collect 4% or more, tax free (note: taxation treatment of CEFs is related to the taxation treatment of the underlying securities. Consult your CPA).
The risk profile of the CEF is somewhat more than if you bought the securities directly. That is because the funds employ leverage. However, much of this risk is simply volatility, meaning that the price of the fund may fluctuate somewhat more than the underlying securities would if held directly. So, when choosing how much of your portfolio to allot to CEFs, be aware that they are somewhat more volatile than lower yielding options. However, the chances of your CEF value going to $0 are very remote. Remember, each CEF has dozens of investments inside of it. It would take a cataclysmic event for that many names to fail all at once.
So, you can shop for closed-end funds by first choosing a sector, then finding funds that cater to that sector. If you are a value shopper, like myself, a different method may appeal to you.
You can run a screen to help you focus only on funds that are currently trading at discount to NAV. This is like going to the Goodwill and hunting for treasure among the trash. If you find ten CEFs where the NAV is worth more than the open market share prices, there will be a reason for eight of those funds. For two out of ten, the shares will just be on sale for no apparent reason. The CEF market is very inefficient, and a determined shopper can find some real deals and steals.
It might seem intimidating at first to sift through hundreds of coals to find a few glittery CEF diamonds. But there is a whole community out there that can help you. Closed-end funds investors are the Trekkies of the investment world. They have a cult-like devotion to their niche, and they often gather online, or sometimes in person, to exchange tips and tricks. People really geek out over closed-end funds (“Set your phasers to ‘profit!’)
There are dozens of newsletters you can subscribe to where they have done a lot of the research for you in terms of identifying undervalued CEFs. These newsletters can range from $9 per month to $99 per month; a great deal compared to the cost of an MBA. There are also countless analysts on Seeking Alpha who specialize in closed-end funds. For a very modest subscription fee, you can browse a wide variety of CEF research.
You can also just do the research yourself. Like anything else, it seems hard at first, but becomes exceedingly easy with practice. In both of the examples that we have discussed in this chapter (Cohen & Steers and Tekla), all of the information you would ever need is posted directly on their websites. You can compare NAV to share price, you can compare NAV to share price over time, you can check out those all-important 19(a) notifications, and you can read detailed biographies of the fund’s management.
When you are working a job for a living, you have no residual. Even though I was an award-winning salesperson, I was only as good as my last sale. I worked, I got results, I got paid. The very next week, it was back to work, hoping to get results, hoping to get paid.
When you teach yourself how to shop for closed-end funds, you only need to do the work one time. It might take you a few months to learn the basics, and a few years to get really good. But once you have learned how to do it, then you know how to do it. You do the research once, you buy the securities once, and then you put up your feet and enjoy the fruit of your hard work for decades to come. Does this sound like a good “job” to you?