What Happened?
The recent downturn in the closed-end fund market was triggered by the meltdown in the subprime market, which had the most damaging impact on institutions that utilize speculative-grade, high-yield debt. Experts suggested this upheaval would have a domino effect throughout the mortgage and fixed-income securities markets, but it now appears to be focused squarely on the high-risk segment.
The "gaming" of the retail-oriented CEF market by institutional investors—due to the elimination of the "tick test1" earlier this summer by the SEC—also added to the downturn in closed-end funds. While we are not arguing that volatility in closed-end fund share prices is uncommon. The off-the-charts sell-off witnessed in August cannot be attributed solely to retail investors.
Institutional sellers purposely attempted to push prices down by "selling short" into an already spooked retail market. These short sales, including "naked shorts2," had the effect of increasing retail investor anxiety. This, in turn, caused an even larger wave of selling by true retail investors. In the end, this activity allowed institutions to cover their shorts at lower prices resulting in attractive short-term returns.
This practice first surfaced in closed-end funds near the end of this year's second quarter. Sponsors noted large block trades and abnormal early volume by firms who had not participated in fund IPOs. Large trading volume early on can impact a new fund's support by its syndicate3.
While it is widely believed that much of the selling can be tied back to retail investors, it is also believed that institutions played a role and will continue to play a larger role in the secondary trading of closed-end funds due to the elimination of the tick test.
Tax-Loss Season
Closed-end fund investors have traditionally begun to weigh the impact of fourth-quarter tax selling by the end of the third quarter. This year, however, fears in the credit markets swiftly carried over to the closed-end fund market in the third quarter resulting in a sharp sell-off in share price and widening of the average fund discount. Most funds were impacted as sellers raced into the market to unload shares. Since this precipitous decline, fund prices have been making a slow and arduous journey back to early-August levels. But the question on everyone's mind is "Will the closed-end fund market see tax-loss selling in the fourth quarter?"
Expectations
With the looming expectation of tax-loss selling during the fourth quarter, we expect existing fund share prices to remain range-bound. It is believed that a majority of the tax selling will take place in older fixed-income funds—specifically, those funds that have experienced market price and dividend erosion during the 2007 calendar year.
That being said, investors can still find plenty of opportunities as much of the market has yet to distinguish between closed-end funds whose objective is income and those whose objective is return. In addition, the potential opportunity is enhanced by the light calendar for new offerings the remainder of 2007.
Opportunities Going Forward
Identifying opportunities in the secondary market can be an arduous task. Investors have been trained to look at discounts and yields as the first signs of an undervalued security. While this is true in some cases, we believe that in the current environment investors should look at a fund's manager's performance or, in other words, the performance of the fund's underlying net asset value.
The closed-end fund market, while very yield oriented, has produced in recent years a plethora of new funds which pay an attractive distribution and, more importantly, invest for total return. Today investors are better served by looking for funds that have produced net asset value appreciation to a point where their cash flows are viewed as more secure. These targeted, long-term investments currently, produce a distribution rate of 6% to 8% and have booked total returns on NAV greater than 15%.