Season Investments


Margin of Safety with Closed-End Funds

Posted on November 6, 2012

"A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world." – Seth Klarman

The phrase “margin of safety” is a commonly used term across many industries. In medicine it is “the amount between a therapeutic dose and a lethal dose of a drug.1” Reckoning back to my engineering classes in school, it was the difference between the designed capacity versus the expected load on a system. The phrase “margin of safety” was first popularized in the investment community by Benjamin Graham in the early to middle part of the 20th century. In The Intelligent Investor, Graham’s second and most famous book on value investing, he emphasizes the importance of investing with a margin of safety.

In the old legend the wise men finally boiled down the history of mortal affairs into the single phrase, ‘This too will pass.’ Confronted with a like challenge to distill the secret of sound investment into three words, we venture the motto - Margin of Safety.

For those unfamiliar with Graham’s work, his margin of safety is achieved when purchasing an asset at a market price below its intrinsic value. In Benjamin Graham’s world this meant buying stocks which traded at less than what he felt they were actually worth, which was based on a fundamental valuation of the company’s current and future earnings.

This same concept can be applied to investing in the fairly niche market of closed-end funds (CEF). In a previous post on closed-end funds, we looked at some of the differences between CEFs and the more commonly used open-end fund. As a brief recap, the main difference between closed-end and open-end funds is that CEFs do not have a mechanism in place which guarantees that investors can get into and out of their investment in the fund at the fund’s net asset value (NAV). Since no such provision exists, closed-end funds are susceptible to the forces of supply and demand in the market. The price of a CEF, much like a stock, is primarily driven by the demand for the shares in the market. But unlike a stock, a CEF has an underlying NAV that can be measured in real time. Therefore, one could argue that it is much easier to quantify the margin of safety on a CEF, which is simply the difference in the CEF price versus the NAV, than it is for a stock since no one really knows the true “intrinsic value” of a stock with any certainty.

This is why we like to use CEFs whenever an opportunity presents itself to buy assets at below their market value in an area of the market we already like. As a real life example, last week we closed out our position in the Morgan Stanley China A Shares Fund (ticker CAF) after the discount had adequately compressed from the point at which we purchased the shares. The chart below shows the actual time period for this holding where the shares were purchased at a 10.2% discount to NAV in mid-April and sold at a 3.4% discount in early November.


At the time of purchase, the fund’s discount to NAV was significantly below its long-term average discount of around 4%. Like many things in investing, the discount/premium of a CEF tends to mean revert over time, which was what we were counting on when we made our purchase. Once the discount began trading above its long-term average, we felt it was a good time to exit the fund and replace the holding with similar exposure in another fund because we still like the underlying exposure to China and emerging markets in general.

The total return for this particular trade wasn’t great as we ended up down a little less than a percent, but the margin of safety still helped us out. The total return for the underlying assets or NAV of the fund over this same time period was -7.5%. In other words, the return on the assets of the fund were a headwind (-7.5%) while the discount compression provided a tailwind (6.8%). In hindsight, we would have been better served buying a more broad based emerging market ETF or better yet a large cap US fund, but this is exactly why we need the margin of safety. As Seth Klarman stated in the opening quote, a margin of safety “allow(s) for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world,” which is true today more than ever.

Contributor: Elliott Orsillo,CFA

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