CEF 101: Don’t Buy Funds At Abnormal Premiums

Investors in closed-end funds have to contend with different risks and analysis criteria than ETF or open-ended mutual funds.  Those that have spent any length of time in this space have more than likely learned how important it is to look beyond distribution yield, recent price trend, or the touch of a star fund manager.  While these characteristics are important, they can easily be overridden by an exorbitant premium or fundamental catalyst that turns the corner.

A recent example of this phenomenon comes in the form of the popular Doubleline Opportunistic Credit Fund (NYSE:DBL).  This fund was the first closed-end vehicle to be released by Jeffrey Gundlach at DoubleLine Capital in 2012.  It has thrived under the stewardship of his investment committee, posting average annualized market price returns of +12.00% from inception through 8/31/16.

The strategy is essentially a leveraged off shoot of Gundlach’s other flagship fixed-income strategies.  It carries a high degree of mortgage-backed security exposure with flexibility in risk management and/or sector positioning.

As you can see on the 1-year chart below, the share price of DBL really started to shoot higher versus its underlying net asset value (NAV) near the end of 2015.  This peaked with a premium of greater than 17% in September 2016 despite the fact that the NAV has essentially traveled a sideways path.

*Source: Morningstar.com

More recently, the uptick in interest rates, combined with the flighty nature of closed-end fund investors, caused a sharp correction in DBL’s market price.  The fund is now trading at just a 5.41% premium to its NAV as of October 13 (according to Morningstar data).  That 12% decline in market value came with little fluctuation of the underlying portfolio holdings.

Furthermore, investors who were aggressively purchasing DBL throughout 2016 should have been aware that this rising premium was somewhat of an abnormality.  The 3-year average premium for this fund is listed at +4.88% and it has even traded at a discount several times between 2013 and 2015.  This skewed risk profile should have set off alarm bells for those who were paying attention to these relative valuation metrics.