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Watching the Forest AND the Trees

06/05/2013

Investors often ask us for the best way to approach closed-end fund investing. Does the traditional buy-and-hold strategy provide the best results or is active trading preferable?

In our view, the answer is a combination of both: taking a long-term view toward different market sectors but actively taking advantage of short-term trading opportunities along the way.

Two Moving Targets for Closed-End Funds

When analyzing which closed-end funds to buy or sell, there are two metrics to consider:

NAV: Just as with an open-end fund, the net asset value (NAV) measures fluctuations in the fund’s underlying portfolio. What is the expected long-term direction of the fund’s NAV? Does it move with the equity markets, the bond markets, or in line with a specialized focus?
Share Price: Closed-end funds trade on the stock exchange, so while their share price is influenced by changes in NAV, it is ultimately determined by the pressures of supply and demand. This provides short-term volatility, and in some cases, sharp fluctuations, leading to instances where investor sentiment can create trading opportunities.

Peaks and Valleys
Investor sentiment for a closed-end fund can be quantified by whether it is trading at a discount or a premium to its NAV. This chart shows the average valuations of the four largest closed-end fund sectors over the past year and a half.
Herzfeld
Source: Thomas J. Herzfeld Advisors, Inc.

Equity sectors, represented by the green and blue lines, have been trading primarily at discount valuations.

Over most of the same time period, investors favored bond funds. Given the low interest rate environment of the past several years, this is understandable. The inverse relationship that exists between interest rates and bond prices has translated into strong performance for bond funds, especially for the majority that use leverage. Furthermore, prevailing upward-sloping yield curves have allowed the funds to earn and pay out attractive distribution yields. As a result, both taxable and municipal closed-end bond funds have primarily traded at strong discount/premium valuations, represented by the red and grey lines.

Notice how average discounts widened, then recovered, several times in reaction to headline-related events, creating trading opportunities. For instance, after reaching a peak in late September 2012, discounts briefly widened for both taxable and muni bond funds, which had been trading at average premiums, as well as for specialized equity funds, which had been trading at relatively narrow valuations. That shakeout followed the U.S. presidential election and a strong reaction by investors to uncertainty surrounding the impending "fiscal cliff."

A New Opportunity?

In our opinion, a similar opportunity exists in investors’ recent reaction to the rapid rise in the yield on the 10-year U.S. Treasury bond, from 1.625% in early May to a high of 2.165% at the end of May. The discussion surrounding the potential trajectory of interest rates has slowly changed from "if interest rates rise" to “when interest rates rise.”

Over the past few days, however, closed-end fund investors are no longer asking “When?” but have responded with a panicked "Now!"

To nervous investors, we offer these thoughts:

  • The Trees: Our approach is to take advantage of these types of short-term dislocations, buying into discount widening for near-term trading opportunities. Investors are still looking for yield and are apt to be lured back to bond fund categories by still-attractive payouts and discounted prices, providing an opportunity for a quick profit.
  • The Forest: As investors slowly assimilate the potential impact of rising interest rates and potential positive effects of a recovering economy on equities, we expect there will be a gradual shift in their holdings out of bond funds and into equity funds. We don’t expect it to be a smooth transition; rather, we are looking for periodic shakeouts that assume the familiar pattern of overreaction followed by rebounds. By taking advantage of these opportunities, our goal is to establish positions at relatively cheap entry points, using a buy-and-hold approach for sectors where we expect overall discount narrowing but a short-term, in-and-out trading strategy where we think overall discount levels will gradually widen.
Not For the Faint of Heart:
    We recognize that often the biggest challenge is to be a buyer when everyone else is selling and a seller when everyone else is buying. At Herzfeld, this contrarian approach has been the backbone of our trading strategy since the firm’s founding in 1984.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.