Please note, this article was first published on Morningstar.com, a sister site of Morningstar.co.uk, and analyses data from to US-listed CEFs.
The Greek Debt Crisis
Recall that last spring, investors' attention was focused on Greece, where the country faced a large fiscal shortfall. The market feared that this inability to meet financial obligations would spread throughout Europe, with Spain and Portugal being among countries in a similar mess. The very future of the euro as a common currency was said to be at risk.
There are several CEFs that invest primarily in European securities. Although we looked at all of them, the experience of two will suffice. European Equity Fund (EEA) posted a z-statistic of below negative 2 on May 18. It has not had a subsequent z-statistic below negative 2. The closing share price was $5.68, with a net asset value of $6.71 and an absolute discount of 15.3%. The subsequent low closing share price was $5.33 on June 8, representing a paper decline from the buy signal of 6.2%. Including a $0.045 annual distribution paid in December, the total return over the intervening period was 42% through March 3 on the share price. The net asset value return was 31.8%.
Ibero-America Fund (SNF) is interesting to look at as well. Even though the fund invests about 25% of its assets in Latin America, its European investments are focused on Spain and Portugal, two countries thought to have fiscal problems similar to Greece's. It is reasonable to expect that, had there been a true investor panic about the Greek crisis reflected in CEF discounts, this fund would have been hit. However, this did not occur. In fact, using relative discounts and a negative 2 z-statistic to ascertain a buy point, investors would have missed out on an opportunity to purchase this fund. Not once during 2010 did the z-statistic breach negative 2.
Let's say, though, that by sheer chance, an investor had purchased this fund on May 18, when European Equity flashed its lone z-statistic buy signal. What would have been the outcome? The closing share price was $5.26, with a net asset value of $6.03 and an absolute discount of 12.8%. The subsequent market close low was $4.95 on June 9th, which would have represented a paper loss of 5.9%. The fund pays quarterly distributions, so over the course of 2010, the investor would have received $0.36 per share. The closing share price on March 3 was $6.80, representing a 12.9% absolute discount to the $7.81 NAV. The total return from May 18 was 37.8% on the share price and 35.5% on the net asset value--hardly any difference.
Conclusions
While it would be easy to overstate the takeaways from our brief survey, we must bear in mind that this article is looking at two crises and four CEFs. However, there are three conclusions we'd like to focus on. First, it is easy with CEFs to get captivated by the discount and premium phenomenon. As investors, though, all we really care about is the share price that we buy and the subsequent total return. Discounts may widen and narrow: As long as the fund meets our objectives and its total return matches (or ideally exceeds) our expectations, we should continue to hold the security we purchased.
Second, street demonstrations or massive civilian unrest does not necessarily mean an investment opportunity exists. Sure, one could have seen the Thai demonstrations and then patiently waited for the z-statistic to fall below negative 2 (or whatever level one chooses), but subsequent total returns were not much different for the impatient investor who jumped right in after the start of the disturbances. In the case of the Greek debt crisis, the discounts didn't reflect any real panic. European Equity Fund gave one lone buy signal, which Ibero-America Fund did not.
Third, for contrarian investors seeking to buy when panic is at a fever pitch, z-statistics can help, but they are not the sole answer. It's important to bear in mind that discounts and premiums arise from differences between the share price and the net asset value. If a market panic is affecting both the CEF's portfolio valuation and the CEF's share price, the discounts are not going to reflect the panic. This is why Ibero-America Fund didn't have a significantly low z-statistic: On May 18, its then year-to-date return was negative 25.1% on an NAV basis and negative 31.5% on a share price basis. It was a rational--even if panicked--market for both the share price and the net asset value.
Using relative discounts and low z-statistics, as opposed to absolute discounts, to find truly undervalued share prices--and to avoid classic value traps--has its merits. But using them as the primary tool to uncover trading opportunities not only has limits; it could cause you to miss opportunities as well.
