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Earlier this week, we published an article by Morningstar Director of Personal Finance Christine Benz, in which she wrote of risk being the enemy, rather than volatility. As Benz said, it’s easy to confuse the two and this is also true of closed-end fund investing. Let’s take this a step further and look more closely at how investors fare with CEFs.
Volatility
Some investors think of CEFs with low price volatility as low risk, but the truth can be very different. Take the example of private equity or venture capital funds. These can trade infrequently and thus display low price volatility. But a deeper look at the underlying investments shows they’re actually high risk funds; both invest in illiquid and/or unquoted companies for which it can be hard to ascertain a true value at any point in time.
Conversely, a fund that displays higher price volatility is traded more frequently, thus it has better liquidity and probably invests in quoted companies which themselves have good liquidity.
This isn’t a hard and fast rule. Volume statistics can be misleading, as a fund with an imminent corporate action will often see higher turnover leading up to that action than may normally be the case. SVM UK Active (SVU) is one such example; the announcement of a hostile takeover bid by Cyrun Finance led to increased trading from the day the story broke and it took more than three months for the offer to proceed successfully.
Looking solely at the number of shares traded isn’t enough to make a judgment on a fund’s level of volatility, nor can it be the determinant of how risky that fund is. Further, there are more sources of risk besides perceived volatility.
Gearing
There’s the issue of gearing, for a start. I’ve oft been told by advisers that closed-end funds are too risky for their clients, with gearing being cited as a major risk factor. But that suggests that gearing is a bad thing and I don’t necessarily agree. Like all tools, it’s all about how it’s used.
We know that in rising markets, gearing can be performance-enhancing and that in falling markets it exacerbates the impact of that fall. Over the long term, however, academic studies have shown that, used well, gearing adds value. So how do you decide the level of gearing that’s right for you?
The first decision is whether you want any gearing at all. If it’s going to keep you awake at night through worry then it’s not for you. If you’re investing for the long term, though, a modest amount of gearing could add a little bit extra to your portfolio, be it capital growth, income or both.
Let’s look at Baillie Gifford’s Japanese equity funds. Baillie Gifford Japanese is an OEIC, Baillie Gifford Japan Trust (BGFD) the CEF; both are run by Sarah Whitley. The CEF is currently around 10% geared and gearing has just been reintroduced after a period of no gearing since the end of 2010. The current level of gearing is more modest than was the case prior to this period—gearing as a percentage reached into the high 20s in the final quarter of 2008 as markets collapsed. This of course was exacerbated by the market falls and demonstrates well how risky gearing can be in downturns. As the pool of assets shrinks, so the proportion of the fund that is geared rises. For the calendar year 2008, the OEIC managed to post a positive return, albeit modest at less than 2%, whereas the CEF lost nearly 21% on a share price basis and nearly 15% on a net asset value basis. The story was different in 2009, though, as markets started to rally off their extreme lows. The OEIC lost over 4% that year, whereas the CEF’s share price rose nearly 3.5% and NAV 2%. Okay, so that’s nowhere near a recovery of the previous year’s losses but it shows that in rising markets gearing can have a positive effect.
Discounts
Then there’s risk associated with a fund’s discount. There’s no guarantee a fund’s discount will close and the NAV and share price will converge to one common level. So as an investor you need to look at what might be causing that discount and in which direction it is likely to move. After all, there’s money to be made from buying into funds that are at historically-wide discount levels if, and I say if not when, that discount could narrow. (More on this in Don't Invest in CEFs Just for a Discount.)
The board can play a critical role here so that’s another area to consider around where risk can lie. An inert board or one that lacks independence can pose a risk to shareholders by not being proactive in considering ways in which to help control a fund’s discount. Alliance Trust (ATST) has been accused of this by many market commentators as the board refuses to introduce a formal discount control mechanism, despite pressure from activist investor Laxey Partners. That said, they have started to buy back shares periodically so Laxey has certainly had influence, even though the board hasn’t introduced a DCM.
Market Sentiment
Finally, the last risk I want to mention, and one that is linked to the discount, is that the share price is subject to external factors beyond the investment manager’s control. So, back to our Japanese fund examples; investors have shunned Japan for some years and this negative sentiment has without doubt weighed on the share price of the CEF, even though the returns on a NAV basis have fared better. While NAV is the true measure of a manager’s skill, other forces can have a significant impact, particularly at times of market stress. That said, in rampant bull markets it can be a positive.
Understand the Risks for Successful Investing
So, like all investment types, CEFs have their own set of risks which need to be considered but, in my view, that doesn’t necessarily make them more risky than their peers. It just means there’s more that needs to be understood about them.
