Would you willingly pay $1.25 for something worth $1.00? This is not a trick question. The data showing the current price and the actual value is clearly stated and easily accessible. Knowing this, would you pay $1.25 for something worth $1.00?
In a world operating in accordance with the efficient market hypothesis (EMH), such price discrepancies could not exist. If they did appear, they would quickly be corrected. Potential buyers would walk away from the overpriced asset rather than opening their wallets. Potential sellers would lower their asking price until they could find someone to trade with.
In reality, the markets are not fully efficient and some investors do willingly pay a significant premium. We see examples of this occurring in the closed-end fund space. As of Wednesday’s close, the PIMCO Strategic Income Fund (RCS), PIMCO Global StocksPLUS & Income Fund (PGP), PIMCO Corporate & Income Opportunity Fund (PTY) and the PIMCO High Income Fund (PHK) were trading at premiums of approximately 25% or more relative to their net asset value (NAV). Put another way, buyers of these funds are paying $1.25 or more for each $1 worth of assets.
What’s the attraction? Beyond familiarity with the PIMCO name are the high yields these funds trade with. The Closed-End Fund Association (CEFA) calculates their yields as ranging between 8.68% (PTY) and 11.09% (PGP). The distribution yield—which can include capital gains and the return of capital—ranges between 9.22% (PTY) and 12.77% (PHK).
These high yields are possible because of the use of leverage. Global StocksPLUS & Income’s portfolio, for example, has 23.8% of its assets leveraged. The high ratio reflects the use of derivatives such as reverse purchase agreements and credit default swaps. Investors who do not understand what these instruments are should not buy shares in funds that invest in them.
Leverage is often used by closed-end funds to boost returns and distributions. When it works, shareholders are happy. When it backfires, shareholders take a big hit. Leverage is akin to playing with fire: you’re fine until you are burned, and sometimes those burns are severe.
Paying a high premium to own a closed-end fund that makes use of leverage means making two bets beyond the bets that shareholders of mutual funds and non-leveraged exchange-traded funds (ETFs) make in regard to fund-specific return. First, shareholders of these closed-end funds are counting on others to also be willing to pay a high premium to own the fund. Second, these shareholders are hoping to get out of the fund before the use of leverage backfires and the underlying value of the fund’s assets incur a massive drop. It’s risk on top of risk.
Astute and patient investors can find bargains in closed-end funds. The key is to look for situations where you can pay less than a dollar—preferably much less—for a dollar’s worth of assets. The CEFA’s free screener can identify such funds. I like to look at the premium/discount history chart and table on a fund’s quote page to see how the current discount compares with the historical averages. (Some closed-end funds have histories of trading at discounts to their NAVs; I want the current discount to be bigger than average.) I also take into account the fund’s expense ratio, its historical returns, whether not it uses leverage (I personally prefer non-leveraged funds) and the fund’s investment strategy. I will go to the fund’s website—which can be found by doing an online search on the fund’s name—to see what the fund is investing in and to get more information about the strategy.
- Offbeat Offerings: Closed-End Funds – A primer on investing in closed-end funds.
- Seeking Tax-Free Income From Closed-End Funds – The guidance on what to look for given in this 2011 AAII Journal article remains very valid today even though the data is outdated.
- Micro-Cap Stocks Outperform, Often in Consecutive Years – Micro-cap stock returns tend to be streaky, often showing outperformance for two or more years at a time.
- What Studies Say About How Oil Affects Stock Prices – An analysis of more than 100 studies led to three conclusions, and some criticisms.
Just four S&P 500 members are scheduled to report: Brown-Forman Corp. (BF.B). on Wednesday and Broadcom Inc. (AVGO), Cooper Companies Inc. (COO) and J.M. Smucker Co. (SJM) on Thursday.
The week’s first economic report will be April factory orders, released on Monday. Tuesday will feature the Institute for Supply Management’s (ISM) May non-manufacturing Index and the April JOLTS report. April international trade and revised first-quarter productivity will be released on Wednesday.
- The Impact of Saving Versus Return on Wealth
- Stocks: An Underappreciated Asset Class in Retiree Portfolios
- Key Questions About When to Retire
The latest AAII Sentiment Survey shows a decline in optimism among individual investors about the short-term direction of the stock market. At the same time, both neutral and bearish sentiment are modestly higher.
Bullish sentiment, expectations that stock prices will rise over the next six months, declined by 3.5 percentage points to 35.0%. The drop puts optimism below its historical average of 38.5% for the 13th time in 14 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rebounded by 2.4 percentage points to 38.6%. Neutral sentiment is above its historical average of 31.0% for the 15th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 1.2 percentage points to 26.4%. Bearish sentiment remains below its historical average of 30.5% for the seventh consecutive week and the 21st time out of the past 25 weeks.
The decline in optimism follows what had been a 13-week high. At current levels, all three sentiment indicators are within their typical historical ranges.
Many individual investors, but not all, anticipate continued volatility and/or think that the current political backdrop could have a further impact on the stock market. Trade policy is influencing some individual investors’ sentiment. While many either approve of the Federal Reserve’s plan to gradually raise interest rates or don’t expect it to affect the stock market, some AAII members are concerned about the impact that rising rates will have. Also influencing sentiment are valuations, tax cuts, earnings and economic growth.
This week’s special question asked AAII members what influence first-quarter earnings are having on their outlook for stock prices. Nearly two out of five respondents (39%) describe earnings as having a positive impact on their expectations, particularly because they signal growth. Slightly more than 28% say first-quarter earnings had little to no impact. Some of these respondents say other factors, particularly politics, are having a greater impact than short-term earnings on their outlook. Others describe earnings as being approximately equal to expectations. About 10% of respondents express concern about earnings being at or near a peak.
Here is a sampling of the responses:
- “Earnings have reinforced my view of the strength of the underlying economy and the positive effect of the tax bill.”
- “None. They came in largely as expected.”
- “I do not think second-quarter earnings will keep pace and investors will be disappointed.”
- “Minimal in comparison with the uncertainty of political and foreign influences.”
- “I’m more bullish due to strong earnings and revenues.”
Bullish: 35.0%, down 3.5 points
Neutral: 38.6%, up 2.4 points
Bearish: 26.4%, up 1.2 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Local Chapter Meetings
May 24, 2018 Global Stock and Bond Diversification With Just 2 ETFs
May 17, 2018 The Yield Curve Is Getting Flatter
May 10, 2018 Midterm Elections and the Worst Six Months
May 3, 2018 Coming Out Ahead by Doing Less
