It’s a simple one-click indicator that can hand you huge price gains on a CEF you pick up today. And those gains are in addition to the huge dividends these funds pay—the typical CEF yields a life-changing 7% today, and plenty pay out even more than that (often monthly, too!).
Here’s how my strategy works: all things being equal, CEFs focusing on a certain asset class (corporate bonds, say) will perform similarly, and will likely outperform their index. I say they’ll outperform because top-quality CEFs—particularly those that invest outside of stocks—have well-connected managers who get first crack at new issues. Robotic index funds, by their very nature, simply can’t match an edge like that.
But sometimes CEFs dramatically overshoot or undershoot. When that happens, you can expect them to “boomerang” back to their index.
Why does this happen? In most cases, it’s because of a simple market inefficiency: too many buyers (or sellers) drive the fund’s price up (or down), creating a market price that is too far away from the fund’s net asset value (NAV, or the value of its portfolio).
The result? Out-of-whack pricing we can profit from.
There are several CEFs out there that are underperforming today and are ready to “boomerang” back up. Three I’ve got my eye on are the 6.5%-yielding Ivy High Income Opportunities Fund (IVH); the Western Asset Global High Income Fund (EHI), with a 7.7% yield; and the 8.6%-yielding Virtus AllianzGI Convertible and Income Fund II (NCZ).
As we can see below, all three are underperforming my CEF Insider service’s taxable-bond subindex (shown in blue), of which all three CEFs are members.
But this is an anomaly, and it exists in no small part because these funds, which have less than $400 million in assets under management each, are tiny compared to their multi-billion-dollar ETF and mutual-fund counterparts. That keeps them off investors’ radar and sets them up for strong price upside as they get discovered.
And discovered they will be, given the appeal of their huge dividends in today’s zero-interest-rate world. We know this will happen because their longer-term performance is very different from what we’ve seen in just the last six months.
Each of these funds outperforms the high-yield-bond benchmark SPDR Bloomberg Barclays High Yield Bond ETF (JNK) over the long term. This is the natural order of things, as these funds all have a long-term tendency to beat the market.
And you can set yourself up for even bigger upside when your funds are underperforming their indexes and trading at unusual discounts, which all three of these funds are doing today!
In the last year, these three funds’ discounts to NAV have improved a bit, and they’ll likely go higher thanks to the index boomerang effect. How high? A bigger CEF focusing on the high-yield space, the Calamos Convertible & High Income Fund (CHY), gives us a hint…
CHY’s discount has not only disappeared in 2021, despite starting where IVH and NCZ were, but it’s turned into a modest premium that may rise further still.
So what’s happening here? Simple: CHY is a fund of over a billion dollars in assets, which helps it attract more attention from investors. That bodes well for our comparable smaller CEFs, who could likely see their discounts disappear as they grow, causing their prices to pop. The fact that they’re underperforming their indexes gives them an extra upside kicker.
So where does this leave us? With a three-step CEF game plan:
- Look for smaller CEFs that trail their indexes in the short term but outperform in the long run.
- Augment your gains with a strong discount to NAV, and
- Look to bigger CEFs in the same space to forecast your upside.
And let’s not forget step 4: sit back and collect your 7%+ dividends while you wait for your price gains to arrive!
Michael Foster is the Lead Research Analyst for Contrarian Outlook. For more great income ideas, click here for our latest report “Indestructible Income: 5 Bargain Funds with Safe 7.3% Dividends.”