Discounts As “Leverage”
John Cole Scott, CEF Advisors
We love discounts. Discounts are free leverage. If you take a dollar and let me buy it for 90 cents, I can hold it for one year, five years, 10 years, and there’s no cost like if I were to margin my account to borrow 10 percent exposure. The only risk with discounts is that they widen dramatically and never go back.
So discounts, when properly analyzed, are free money, free leverage, and it’s an easy way to potentially make upside if the fund finds a way to narrow that discount over time.
We always tell people that a 10 discount or a 10 premium is anchored off net asset value, so you need to have net asset value performance that fields the dividend. And then if you can buy good net asset value performance that may happen over time, again the future, you’re able to potentially narrow that discount and increase your exposure without having any cost of borrowing like you do in other areas.
In the past, since we’ve been looking at closed-end funds for my entire life, professionally for 16 years, we’ve seen when discounts are super cheap. Today the discounts aren’t wide, they’re not cheap, they’re in the middle range for many sectors and many funds. So we focus in our work, for our clients, on two things. One is correlation. So thinking about reactiveness of a sector to another.
And thinking about the reactiveness of a sector to the risk-on, risk-off trade. So if you look at the beta of the net asset value for a closed-end fund and it’s a higher beta and your opinion is you want to capture that, that’s an add of your portfolio.
If you’re looking to gain some exposure but you want historically lower beta exposure, you can tilt inside the portfolio.
And the last thing I’ll say is we’re able now to do some after-tax estimates for our work and to say the tax friction of this portfolio in this tax bracket is X and Y. Those are known things you can do, after-tax work and reactiveness, that can help clients today.