At Season Investments we build truly diversified portfolios by spreading capital across a variety of different asset classes and by utilizing the best investment vehicles within each asset class to gain the desired exposure. Our holdings include a spectrum of individual stocks and bonds, open and closed-end mutual funds, exchange-traded funds and exchange-traded notes.
Typically, the term “mutual fund” refers to the traditional open-end version in which the fund company has the ability to create or redeem shares on the fly to meet increasing or decreasing investor demand. When investors put money in, new shares are created for them. When they take money out, the shares they sell are retired. The ability to create or redeem shares every day ensures that the share price of the fund is kept perfectly in-line with the value of its underlying assets, or its “Net Asset Value” (NAV). In contrast, a “closed-end fund” (CEF) has a fixed number of shares that can be bought or sold by investors in the open market. As such, supply and demand for those shares can cause the price of the fund to diverge from the NAV of its underlying holdings. This can present unique opportunities or risks for investors.
Economics 101 teaches us that an asset’s price will be set by the supply and demand for that asset. If there is more demand than available supply, the price of the asset will rise until an equilibrium is reached. The recent real estate cycle in the US is an interesting example. During the early 2000’s demand for houses fueled by cheap money and loose lending standards was overwhelming the available supply of housing. Home builders were feverishly working to create new supply but demand kept pushing prices higher. This all reversed in 2007 as the market became overbuilt (excess supply) in the face of tightening lending standards (shrinking demand). As a result, prices have collapsed reducing the incentive to build and generating new demand from buyers who were previously priced out of the market.
Now imagine an alternate universe in which a housing genie could create or remove a house with the snap of his fingers. In this world, the cyclical forces of supply and demand would have no impact on price since there would always be a perfect amount of supply to offset demand. Housing values would therefore be entirely set by fundamentals such as the cost of materials and labor. This is how open end mutual funds operate. The fundamental value of their shares is always set by net asset value (NAV) of their underlying holdings (e.g. a basket of stocks or bonds etc.).
Closed-end funds, on the other hand have a fixed supply of shares. New shares cannot be created when demand increases, and shares cannot be removed out of the market when demand falls. Because of this, the price of a CEF can drift from the NAV of the fund’s holdings. This is known as the fund’s premium or discount. When a fund trades at a premium it means that the market value (price * shares) of the fund is greater than the actual value of the fund’s underlying holdings. An investor who purchases shares that are trading at a 5% premium is essentially paying $1.05 for every $1.00 worth of securities in the fund, whereas an investor who buys at a 5% discount is paying $0.95. At face value, buying a CEF that is trading at a discount to the NAV provides a nice margin of safety for investors, as well as being a potential source of additional return.
We like to pay “sale prices” whenever we can, but it’s also important to consider a fund’s current discount to historical averages. In other words, we won’t get excited about a 5% sale if historically the discount has been 10%. When we utilize closed-end funds we look for the following criteria:
By selecting funds that meet these criteria we set ourselves up to capture additional return if the fund’s discount shrinks back to its long-term average.
As a real life example, we recently closed out of the ING Emerging Market High Dividend Fund (ticker IHD) at around a 3% discount compared to the 8% discount they were purchased at last fall. This fund provided exposure to a geographical region we liked (Emerging Markets) and was trading at a larger discount to its NAV than its historical average.
PREMIUM/DISCOUNT CHART FOR IHD:
The decision to sell the fund and replace the exposure with something else was primarily driven by the nice compression we experienced in the fund's discount to NAV which added around 5% to the returns of the fund's underlying assets. We continue to monitor the universe of closed-end funds for opportunities such as this, which is just one of the ways we add value to our client's portfolios.
Season Investments, LLC
We want Transparency to be one of the defining characteristics of our firm. As such, it is our goal to communicate with our clients frequently and in a straightforward way about what we are doing in their portfolios and why. Regular Macro Updates will address our economic and capital market viewpoints and discuss top-down portfolio positioning. Also watch for Micro Updates which convey our reasoning behind specific investments.
This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities. It represents only the opinions of Season Investments. Any views expressed are provided for informational purposes only and should not be construed as an offer, an endorsement, or inducement to invest.