Terry J. Diehl, The Daily Record Newswire
The Efficient Market Hypothesis states it is impossible to “beat the market,” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the Efficient Market Hypothesis, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. This hypothesis is a cornerstone of modern financial theory, but is highly controversial and often disputed. How would you explain how Warren Buffett or any other manager can consistently out-perform the market over long periods of time?
Testing the Efficient Market Hypothesis is often difficult. A direct way to test this hypothesis is to compare the prices of assets to their intrinsic or fundamental values. That is, the expected present values of future cash flows. Intrinsic values are not easily observable to identify the correct pricing for a particular investment.
There is one class of securities whose intrinsic values are relatively easy to measure, Closed-End Funds. Most mutual funds are open-end funds in the sense that the fund stands ready to accept more money at any time and will redeem shares for current shareholders at the “Net Asset Value” of the fund.
In the case of a Closed-End Fund, management raises a certain amount of capital, say $100 million, buys a portfolio of securities it will manage according to its charter, and then issues a fixed number of shares, say 10 million. The shares are traded on organized stock markets, mainly the NY Stock Exchange. Any shareholder who wants to liquidate must sell the shares at the market price. The share price is set by supply and demand, and can therefore diverge from the net asset value. The prices of CEF’s often do diverge from their net asset values.
There are 4 sets of facts regarding Closed-End Funds that are anomalies to the Efficient Market Theory.
1.) New funds appear on the market at a premium or Net Asset Value and move rapidly to a discount. New funds tend to be started among “hot” sectors or areas of the market that have been in demand. Oftentimes, there is a large commission associated with these new funds to encourage brokers to sell them to their top clients.
2.) Closed-End Funds often trade at substantial discounts relative to their net asset values. Over a 20-year timeframe, there was a study performed by three finance professors (Lee, Shleifer and Thaler) that the average discount on a portfolio of major Closed-End Stock Funds in the United Sates was 10.1 percent. So why are discounts the norm, and why aren’t prices equal to net asset values?
3.) Discounts and Premia are subject to wide variations, both over time and across funds. In a 30-year study of one of the largest U.S. stock funds, Tri-Continental Corp (symbol TY), the year-end price of Tri-Continental varied from a 2.5 percent premium to a 25 percent discount to its Net Asset Value. Average discounts also display a seasonal pattern; discounts tend to shrink in the month of January. This is striking because the assets the fund owns do not display a January effect. Discounts vary widely across funds. It is common to see some funds selling for large discounts while others sell at substantial premiums. Puzzle #3 Why do discounts vary so much over time and across funds?
4.) When CEF’s are terminated, either thru merger, liquidation, or conversion to open-end funds, prices converge to reported Net Asset Value. So if the markets are efficiently priced, and the prices of closed-end funds, then why does the price rise to eliminate the discount when the funds are open-ended?
Closed-End Funds are a unique investment that are a conundrum to those who ascribe to the Efficient Market Theory. They take a lot more research and study as one can surmise by the above. However, they offer repeatable, exploitable opportunities time and again. After all, isn’t that what we are looking for as investors?
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Terry Diehl is a vice president for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
