Saturday, May 16, 2009

CLOSED END INVESTMENT COMPANIES: Hopefully Lessons Learned and To be Applied

I mentioned in an old post why I considered keeping my closed end investments companies in 2008 to be the worst mistake that I made that year. Buy High & Sell Low /Retrospective on the Good & Bad For those unfamiliar with that class of investments, a closed end investment company is similar to a mutual fund except the shares trade on a stock exchange and there is a fixed share capitalization.   The price of the shares is not set by the NAV but by investors buying and selling their shares to one another just like any other stock. This means that the price at any given moment may be below NAV or even above.  The ones that I own were purchased initially at a deep discount to NAV, sort of like buying a dollar for eighty cents which sounds appealing.   Generally, during ebullient periods, the discount may narrow to NAV, as investors become more comfortable about stocks, and then I would sell some shares.  If the market was rising, I could make money in two ways, an always appealing proposition to an old codger, by an increase in the NAV and the narrowing of the discount.  Sounds like one of those money printing machines that the wizards at AIG's Financial Products Unit in London believed they had discovered at least until they blew up AIG. Buy of 50 WBS: Lottery Ticket/The Long Tail Contract/AIG FP & Lack of Adult Supervision/TGB upgrade
I started trading closed end firms in 1983 with the purchase of one of the oldest ones, Adams Express (ADX), and I currently own shares in it.   


I always have a tendency to bet a little against whatever I believe to be a likely outcome.  An example would be selling all small caps in 2007 and keeping two closed end investment companies in that sector, RVT and RMT, just in case I was wrong about a bear market developing. Another example was keeping virtually all of my closed end funds in 2008, notwithstanding my belief about the likely course of the market.  They were sort of a hedge against my opinion being wrong about the likely course of events.  So, I decided to go with some new funds, or stick with some old ones, that provided what I thought to be a measure of protection in the event of a downturn, funds that use a buy-write option strategy for example to hedge downside risk or a fund like OLA which goes long 100% and short 30%.  Then I emphasized several funds that had a good dividend yield at the time, paying it monthly, which I would reinvest in shares.  So, if the market starting going down, I would in effect be averaging down monthly by using the good monthly dividends to buy more shares.  I thought this would provide some protection and may prove beneficial during the next bull market.  So, wasn't I being rational?  Maybe a little for an average bear market, both in length and severity, but not the one that we are in now. 

I would say that the average closed end fund that I owned fell about 50% in value in 2008, and they were without a doubt my worst category.  I had sold down most of my mutual funds before 2008 even started (except I added a 2010 Target Fund and Janus Balanced, and kept all shares in the Permanent Portfolio),  and may have pared a few of the remaining ones in early 2008.  But, I did nothing with a large closed end fund position, other than suffer the losses. 

Recently over the past few months, I decided to forgo using the dividend to buy additional shares.

My plan now is to jettison all of them, down to the last share, during the next bull market, probably at a point after the next Trigger Event coming out of a Stable VIX Pattern.  Then I will look for an opportunity to start buying some of them back.  So what happened in 2008?

First of all, in a market downturn, no one in my opinion should own a leveraged closed end fund.  With leverage the fund buys more than it otherwise could, and the more you buy in a bear market-THE MORE YOU LOSE!  Actually, it is worse than that for several funds that had to sell securities at the worst possible moment in order to reduce their leverage.  Several of the closed end funds in the real estate area just about imploded, with some finding their way very close to zero.  Leverage can work in a bull market, when the fund can borrow money at favorable rates and use those funds to buy more assets that will return an excess return over the cost of borrowing.  I do not invest on margin, but I do at least understand how it can work in one's favor under certain circumstance.  But leverage works both ways and it is best just to avoid a fund using it in a bear market.  But, I understood that problem and largely avoided it, though I still have a position in FAX which uses leverage and a few smaller positions.

No, what killed me was that nothing worked during this last bear.  The discounts to NAV increased greatly as individual investors panicked and the funds lost as much or more than their counterparts in the mutual fund arena.  So my strategy of buying buy/write funds like ETW, IGR, IAE, IGD and EOI did not work and the dividend investment strategy only added to the losses.  Eventually, those shares purchased may help me dig my way out of the hole during the next bull market.  For now, however, they just made the hole deeper. 

If anyone is interested in buy-write closed end funds that I mention above, here are the links to the sponsor's web pages: 

One positive feature about those funds is that they have maintained so far their generous dividends.  I see no reason to take a loss on any of them.   But they did hurt me last year along with several others, including EBI, OLA, BCF, PSY,  SWZ and many others.

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