A Strategy for Losing Money
by Charles Rotblut | July 14, 2016
I can give you a name of a fund trading with the equivalent of a 23% sales charge. It’s actively managed by a company that’s incurred large outflows from its signature mutual fund following the departure of its star chief investment officer. Interested in owning it?
You probably aren’t, but some investors were. PIMCO’s Municipal Income Fund (PMF) , a closed-end fund, traded at a 23.4% premium to the underlying value of its net assets last Friday. Put another way, some investors were paying $1.23 for $1.00 worth of net assets. One doesn’t have to know much about investing to realize this isn’t smart.
PIMCO Municipal Income Fund wasn’t the only offender. Eight other closed-end muni bonds funds ended last week with premiums of 10% or more. In comparison, the average closed-end bond fund traded at a 2.32% discount (meaning investors paid just under $0.98 for every dollar of assets), according to the Closed-End Fund Association (CEFA). The average stock closed-end fund traded at a 7.49% discount.
For those of you who are curious, here are the highly priced bond funds, sorted in descending order by their premium based on data for last Friday (July 8) from the CEFA:
- PIMCO Muni Income (PMF), 23.40% premium
- PIMCO NY Muni Income II (PNI), 21.62% premium
- PIMCO CA Muni Income III (PZC), 16.78% premium
- BlackRock VA Muni Bd Tr (BHV), 15.27% premium
- Pimco CA Muni Income II (PCK), 15.27% premium
- BlackRock MuniYld AZ (MZA), 14.71% premium
- PIMCO CA Muni Income (PCQ), 12.52% premium
- BlackRock MuniVest II (MVT), 11.97% premium
- PIMCO NY Muni Income (PNF), 10.59% premium
The premiums on several of the funds have come down since last Friday, but still remain high. As of yesterday, PIMCO Muni Income trades at an 18.89% premium.
Closed-end funds differ from mutual funds and exchange-traded funds (ETFs) by having a fixed number of shares. As money flows into and out of mutual funds and exchange-traded funds, the number of outstanding shares is adjusted. Mutual funds directly issue shares to and redeem shares from shareholders. ETFs adjust their share counts through creation units, which are large blocks of shares issued to and redeemed from institutional investors and large traders. If there are more investment dollars flowing into a closed-end fund than the net value of its assets, shares of the fund will trade at a premium to their net asset value (NAV). It’s the law of supply and demand. More dollars will drive up the share price because transaction proceeds go into the pockets of selling shareholders, but never into the closed-end fund. (New investor dollars only flow into a closed-end fund when an offering occurs, which is not very often.)
This fact invokes the greater fool theory. When a premium, particularly a high premium, is paid, the investor is hoping there is someone willing to pay an even higher price for the same shares. Two events could cause this investor to incur a loss. The first is the fund’s net asset value declining, which should cause the share price to decline and is an inherent risk with any type of fund. The second is a decrease in the premium. Should the premium decline faster than the fund appreciates in value, the investor could lose even though the underlying net asset value of the shares increased in price. The worse-case scenario, of course, is for the fund’s NAV to decline and its premium to shrink—a double whammy.
How do you avoid such a scenario? Check the Closed-End Fund Association’s website. They list a closed-end fund’s premium or discount right on the quote page. I also find their screener to be very helpful. (Click on "fund selector" near the top of any page.) You can screen by type of fund as well as by other characteristics, such as premium and discount.
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Seeking Tax-Free Income from Closed-End Funds – This 2011 AAII Journal article provides good timeless suggestions on what to look for in a closed-end bond fund. Just keep in mind that it was written at a time when closed-end muni bond funds were trading at big discounts.
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Liquidity: The Hidden Risk in the Municipal Market – One big challenge with muni bonds is their low levels of trading volume.
Optimism among individual investors about the short-term direction of stock prices is at a level not seen in over four months, according to the latest AAII Sentiment Survey. Meanwhile, neutral sentiment and bearish sentiment both declined.
Bullish sentiment, expectations that stock prices will rise over the next six months, jumped 5.8 percentage points to 36.9%. Optimism was last higher on March 9, 2016 (37.4%). Even with this week’s increase, bullish sentiment remains below its historical average of 38.5% for the 36th consecutive week and the 69th out of the past 71 weeks.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, pulled back by 3.6 percentage points to 38.7%. Neutral sentiment is above its historical average of 31.0% for the 24th consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, declined 2.2 percentage points to 24.4%. Pessimism was last lower on since April 20, 2016 (23.9%). The historical average is 30.5%.
Since registering 22.0% on June 22, 2016, optimism has rebounded by 14.9 percentage points. Though it’s a big move, some context is needed. First, as noted above, bullish sentiment remains below average. Secondly, this is just the second time since last November that optimism has exceeded 30% on consecutive weeks. Bullish sentiment was above 30% during the three-week span of February 24 through March 9, 2016.
The rebound in stock prices and the new record highs set by the S&P 500 have had a positive impact on some individual investors. Others are encouraged by the sustained economic growth. A view that there is there is no good alternative to stocks is contributing to the optimism. Giving reason for caution or pessimism is global economic uncertainty (including Brexit), the prevailing level of valuations and disappointment with corporate earnings growth. The presidential election and monetary policy are also impacting individual investor sentiment.
This week’s special question asked AAII members how the recently set new record low for Treasury yields is affecting their short-term outlook for stocks. Nearly four out of 10 respondents (37%) said that the new lows are not altering their outlook for stocks. Reasons were mixed, though several cited a lack of good alternatives to stocks or their adherence to a long-term allocation strategy. Nearly 33% of respondents are either more optimistic or said that the low bond yields make stocks attractive. Several of these respondents noted the comparatively higher yields that dividend-paying stocks are trading with. About 15% say that the low bond yields are making them more cautious or pessimistic. These respondents fret about valuations, investors being pushed to take on more risk and what might happen if bond yields begin to rise significantly.
Here is sampling of the responses:
- "Low interest rates are leading investors to bid up stock prices above the appropriate level.”
- "No impact. I am a long-term investor, not a short-term trader.”
- "Dividend payers are looking better and better.”
- "No impact. Stocks still pricey, but better than other options.”
- "Positive, especially for dividend stocks.”
Bullish: 36.9%, up 5.8 points
Neutral: 38.7%, down 3.6 points
Bearish: 24.4%, down 2.2 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
July 7, 2016 Two Non-Financial Ways to Boost Your Wealth
June 30, 2016 Your Reaction to Brexit May Be the Wrong One
June 23, 2016 The Debate Over Retirement Income Strategies
June 16, 2016 My Notes From the Morningstar Investment Conference
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