What Type Of CEF Investor Are You?
What Type Of CEF Investor Are You?
Closed-end fund investors often fall into one of two camps:
Yield chasers
Contrarian total return investors
Yield Chasers
The first group is fairly straight forward. They are looking for a means to generate income in what is now a yield-less world. Interest rates post-recession have plummeted to nearly zero causing a very distorted market. Savers have been forced down the risk spectrum into far more risky assets for the same returns they were used to.
Look at the chart below. It shows the income generated on $100,000 invested in six month t-bills. In 2007, prior to the recession, that $100,000 earned $4,500+. Just two years later, that same $100,000 generated just $210. That is over a 90% decline in your income earned.
Since then, we have seen a massive shift in the markets, mainly by do-it-yourself investors. Those investors then started exhibiting classic yield-chasing behavior - primarily by adding on many layers of risk simply to achieve the same goal.
The most common shift we saw was moving into the dividend stock space for your "bond yield." There Is No Alternative ("TINA") became pervasive and these investors simply loaded on risk. And it has worked. For the last ten years, dividend stocks of all forms (high yield, dividend growth, etc) performed very well, in some cases exceeding the S&P 500 index itself.
It is unknown how this will all end but it is our belief that most of these investors do not realize the amount of risk they taken on. A bond with a yield of 5% versus a dividend stock with a yield of 3% and dividend growth of 5% are on far different places on the risk spectrum.
Financial advisors, on the other hand, have for the most part just downgraded their return expectations (the good one's anyway). The bad ones either greatly increased their clients' portfolio risk or continued to believe that their 60/40 portfolio would produce total returns north of 7%.
In summation, the main problem with yield chasing is that you tend to take on excessive risks - sometimes without even knowing. This is especially prevalent in the CEF universe where retail investors tend to be lured in by higher yields. The movement towards managed distribution policies where funds pay a certain distribution yield based on NAV has exacerbated this. These distributions often have gains and even return of capital in addition to ordinary income. But most investors do not even realize it.
Yield chasing is pervasive in all financial markets. We see it constantly with investors becoming enamored with complex and opaque securities like CLOs and MLPs which pay higher yields. They often do not understand the excessive risks in these types of securities. Unfortunately, it won't be until the next recession that many of these investors realize it. And then on to the next big theme!
Contrarian Total Return Investors
By definition, if you invest for the total return in the CEF space, you are a contrarian investor. The goal being to buy highly discounted CEFs that pay a juicy yield with the potential for the price reverting to the mean.
Mean reversion is the concept that prices tend to revert back to a long-term average. In the case of CEFs, the discount tends to be pulled towards the long-term average discounts. Funds with the largest discounts tend to see the price increase narrowing the discount while those with the largest premiums tend to fall reducing the premium.
There are numerous research papers that show when you buy CEFs trading at anomalously large discounts to NAV - in other words trading well below the average discount the fund typically trades- that you'll likely be able to sell those funds at a tighter discount eventually. In those cases, you collect the yield that the fund pays PLUS the capital gain produced when the discount tightens.
Why does this concept occur in CEFs?
The CEF space is a fairly unique one in that it is dominated by retail investors. The size of the space (~$550B) is too small for many of the institutional players to operate. Approximately 75% of all shares are owned by do-it-yourself investors while the rest are owned by advisors on behalf of clients.
Irrational investor behavior tends to produce bad outcomes for most of these investors. The low liquidity of the space and the lack of an institutional presence means there is very little efficiency. These retail investors tend to invest by emotion rather than fundamentals. They are primarily guilty of chasing yield, chasing performance, and selling funds for sometimes ridiculous reasons.
This is the catalyst for these anomalous discounts to exist. We saw a lot of it last Christmas when a confluence of events created a particularly great opportunity to buy shares of nearly every CEF. Money flow is a particularly strong indicator for these discounts. When a particular asset class is out of favor, and money is flowing out, discounts tend to widen out as a "rush for the exists" environment is produced.
The contrarian investor is standing by ready to pounce when this scenario occurs when discounts are at their widest and capitulation has set in. Last December, we saw a particularly weak environment cause retail investors to sell their shares. Add in what is typical tax loss selling in the last few weeks of the year and you had what amounted to a perfect storm of selling.
Using PIMCO Dynamic Credit and Mortgage (PCI) as an example below, we can walk through an illustration. In September of 2018, PCI was trading at a premium to NAV. Then the fourth quarter started and equities began to fall and bond spreads began to widen.
This caused the NAV of PCI to start to roll over (the blue line above). That was exacerbated by the special distributions the fund paid making the NAV decline look worse than it really was. Lastly, the price fell from $24.50 in September to $23 at the start of November to $22.50 by early December. Investors then used this opportunity to tax loss harvest (after all that is what they've always been told).
This sent the shares into a free fall going from $22.52 on December 12th to $20.00 on December 21st, a decline of 11.1% in 7 trading days. The NAV declined but only by 2.1%. In other words, the discount widened by 9% in 7 trading days. That is irrational trading and something the contrarian investors are on the lookout for.
The caveat here is that the contrarian investor often buys when there's blood on the streets and sell during euphoric times. But after selling, they need to wait for the next opportunity to buy in- and that can take a lot of time. A contrarian investor can be sitting on large amounts of dry powder waiting all the while cutting off their income spigot. That is a key consideration that an investors needs to ponder when selling at tight discounts.
Concluding Thoughts
Although these are extreme examples of each type of investor, all CEF investors tend to fall into one of these two groups. The trick is for the yield-chaser to understand the risks in the underlying fund - something we attempt to do- and for the contrarian investor to pounce when the time is right and sell when the discounts are tight. This can be a easier said than done. When your quote screen is a sea of red, and you're the only buyer, it can be quite lonely.
As Sir John Templeton once said "The time of maximum pessimism is the best time to buy, and the time of maximum optimism is the best time to sell."
Continuing on the quote theme, Lord Rothschild stated "The time to buy is when there's blood on the streets."
And the great Warren Buffett has said, "We simply attempt to be fearful when others are greedy, and to be greedy hen others are fearful."
Lastly, Bernie Schaeffer has said "as contrarians, the only thing to fear is the lack of fear itself."