Closed-End Funds Still Scary-Cheap

Is the recovery in closed-end funds a trick or a treat?

This summer's credit crisis severely spooked closed-end fund investors, frightening many right out of their holdings and into the relative safety of Treasury bonds. Discounts were stretched during the selling storm, as fund managers unceasingly unloaded their CEFs until the Federal Reserve saved the day with a surprise 50 basis point reduction of its discount rate.

The market has steadied since then, but TheStreet.com checked in with Dr. Richard Shaker, portfolio manager of Shaker Financial Services and former chief of mathematical research for the National Security Agency, to see if the rebound is for real and not merely a Halloween prank.

Based in Annapolis, Md., Shaker manages $77 million in assets, employing various closed-end fund trading strategies, most notably discount mean reversion. Shaker's composite managed accounts were up 17% for the year (as of Oct. 26), compared to the S&P 500, which returned just below 10%.

TheStreet.com: Quant funds had a terrible August. You use a quantitative approach in trading closed-end funds. Were you affected?

Shaker: Mid-July through mid-August was hard. Although the classical quant funds like Goldman and Renaissance had severe difficulties the week of Aug. 6, our darkest days were Aug. 15 and 16, when there was massive liquidation of CEFs, many opening down 10%. CEFs as a class significantly underperformed the market during this period, yet somehow we came through it with performance no worse than all the relevant market indices during July and August.

Partly this was because our strategies continued to value-add, making up for losses in our inventory. Partly it was because we aren't completely "black box" in our approach. Our trading team got very little sleep during this time and tweaked our strategies to reflect the day-to-day new realities of the summer.

Did closed-end funds as a class recover? Are they no longer undervalued?

I would say they are still quite undervalued. One basket of 188 CEFs we trade frequently -- an equal number of bond and equity funds -- had an average discount of 3.2% at the end of 2006 and now has an average discount of 9.2%. The average discount from July 1 to Aug. 14 widened from 5.1% to 9.3%, then "crashed" to 12.8% during the two bad days. Our CEF basket recovered following the first Fed intervention, with the average discount narrowing over 600 basis points to 6.5% on Sept. 6, but since then it has widened back to its Aug. 14 level.

Bond funds seem even more undervalued than equity funds. In our database, bond funds have widened 5.5% since July 1, vs. 3.2% for equities. The worst culprits are the preferreds like the Nuveen Multi-Strategy Income and Growth Fund ( JPC) and the resets such as the Eaton Vance Floating-Rate Income Trust ( EFT), but, in general, bond funds seem to be compelling buys on a discount basis, while simultaneously being vulnerable to tax-loss selling. Determining whether a given fund is a compelling buy or a tax-loss candidate that should be avoided is a tricky job, and we don't have a simple algorithm to do it.

Do you think that tax-loss selling has already begun?

Yes. Our studies show that CEFs most vulnerable to tax-loss selling are those with low discounts or small premiums. Whereas most CEFs have recovered from their mid-August lows, many low-discount funds haven't. Examples abound in the small- and mid-cap sector such as the Royce Value Trust ( RVT) and the covered-call writing sector in names like the Nuveen Equity Premium Opportunity Fund ( JSN). So that's evidence to us that tax-loss selling has begun.

These CEFs have discounts that are, on average, 7% to 8% wider than their July average, before the general widening happened. They seem to be such bargains that we have positions in many of them, even though we fear that may be "catching a falling knife."

Anything new in trading opportunities?

Most recently, we've taken advantage of increased volatility in certain international equity funds. It's been possible to trade positions with holding periods of less than two weeks and pick up discount differences of 5% or more. Funds we traditionally traded -- and have been very friendly to us the past few weeks -- are Chile Fund ( CH) and Emerging Markets Telecommunications Fund ( ETF). But we also made good profits in three newcomers to us: Spain Fund ( SNF), Aberdeen Australian ( IAF) and Indonesia Fund ( IF).

Our largest position is in Zweig Fund ( ZF), a domestic equity fund. It is recovering nicely from the selling pressure from its rights offering.

You maintain a significant exposure to emerging markets in your portfolios. Does talk of a "China bubble" worry you?

I, personally, believe that Asia ,ex cluding Japan is a great place to be, but we don't have the expertise to comment knowledgably. We have a standard allocation we suggest to clients, but we allow them to decide how much exposure to emerging markets they want. For us, the Asian funds, and the Chinese funds in particular, provide frequent trading opportunities that are too lucrative to ignore. Sometimes China Fund ( CHN), sometimes Templeton Dragon Fund ( TDF), sometimes JF China Region Fund ( JFC) is our Asian largest position.

In the short-term, the Asian CEFs have a lot going for them. Not only are they immune from tax-loss selling, but their large capital gain distributions should attract "dividend capture" interest. We mentioned Korea Fund ( KF) last time we spoke. That fund's distribution, announced two weeks ago, turned out to be even larger than predicted, and their discount has narrowed 5% since the announcement.

Any activists making trouble that you're taking advantage of?

We've benefited from activist pressure on a few funds this year and we will soon be tendering our shares of MFS Government ( MGF).

We continue to hold our position in Bancroft Convertible ( BCV), even though the discount has narrowed considerably. Bancroft management seems willing to fight the activists, but that can all change suddenly. We were surprised at the proposed open-ending of Alliance All Market ( AMO). We don't know where the pressure came to do this for a fund that has often traded at a premium. But that's what's wonderful about CEF's: Some die, others are born, and the profit potential remains for active traders and smart investors.

Before joining TheStreet.com, Gregg Greenberg was a writer and segment producer for CNBC's Closing Bell. He previously worked at FleetBoston and Lehman Brothers in their Private Client Services divisions, covering high net-worth individuals and midsize hedge funds. Greenberg attended New York University's School of Business and Economic Reporting. He also has an M.B.A. from Cornell University's Johnson School of Business, and a B.A. in history from Amherst College.

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