CEF 101: Don’t Buy Funds At Abnormal Premiums

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The lesson here is that loading up on a leveraged fixed-income portfolio trading at a significant gap above its historical average is a risky proposition at best.  There are some closed-end funds that trade at persistent premiums all their life.  However, it’s easy to identify these outliers and potentially justify their existence though some simple analysis at a free website such as Morningstar or CEFConnect.com.  All other funds that appear to be temporarily stretched relative to historical norms should be viewed with skepticism and caution.

We have owned DBL for clients in our Dynamic CEF Income Portfolio at various times over the years and ultimately believe it will work its way back into our holdings in the future.  However, we were net sellers of this position in late 2015 and mid-2016 as the premium started to significantly increase.  This type of fundamental examination is part of our ongoing due diligence and comparative research process to identify overvalued areas of the market.

Conversely, the same style of analysis can be used in reverse to detect funds showing strong relative value below their historical averages.  Periods of stress in the credit or interest rate markets can ultimately lead to closed-end funds trading at meaningful discounts.  Those are often the best times to strike.

Note: This article is written by David Fabian and was originally published on the FMD Capital Management blog. FMD Capital Management is a fee-only investment advisor which provides daily updates on ETFs, portfolio strategies, and market insights. Contact them for a free portfolio review.

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