Avoid These Incredibly Overvalued Closed-End Funds

Many closed-end fund investors are quite well-informed. They understand the intricacies of relatively complex investment vehicles, diligently read the footnotes of their funds' annual and semiannual reports, and are disciplined enough to know when to buy and sell their holdings. However, it appears some investors less familiar with CEFs are willing to venture far outside their circle of competence for the sake of picking up some extra income. As a result, some CEFs that pay high distributions are occasionally driven up to exorbitant premiums. Experienced CEF investors generally steer clear of these funds, but this may not be as obvious a move for CEF newbies. The easiest thing that investors can do to protect their money is to avoid extra-high high premium funds at all costs. In particular, the following two funds appear so egregiously overvalued that only recklessly bold investors would consider buying them at their current valuations.

Aberdeen Chile Fund (CH)
One of the key tenants of the efficient market hypothesis is that arbitrage opportunities should not exist. If they did, investors would merely arbitrage them out of existence. Under this line of reasoning, Chilean equity fund Aberdeen Chile is completely dumbfounding.

Considering that this is a fairly small fund, with a market capitalization of $108 million and an average daily trading volume of $700,000, its volatile share price relative to its net asset value is understandable. But for the decade ended April 2014, market forces have typically kept share prices in line with reality; the fund logged an average 1% discount for that period. But the fund has seen some odd technical patterns in the last year, with higher-than-average trading volume sending the fund to a 29% premium in August 2013, to a 2% discount in December 2013, and then to a 33% premium in January 2014. Shares traded at a 14% premium on April 14, which was long way from its high earlier this year, but still 1.6 standard deviations above its 10-year average.

And here's the mind-boggling part: Aberdeen Chile is an entirely unremarkable fund that has by no means exhibited stellar performance. In fact, the fund has been neck-and-neck with iShares MSCI Chile Capped (ECH) in terms of NAV performance since the exchange-traded fund launched in late 2007. ECH keeps an almost identical portfolio, charges drastically lower fees (0.62% compared with Aberdeen Chile's 1.91% in fiscal 2013), is a more liquid vehicle, and has always traded relatively close to its NAV (because it's an ETF). One would expect Aberdeen Chile to trade at a massive discount instead of a massive premium with these disadvantages.

While the CEF's recent premium is certainly puzzling, there are two likely explanations for its existence. First, it currently touts a distribution rate of 10.8% at share price. To the uninitiated investor, this seems like a great deal. Upon further inspection, it looks significantly less attractive: The fund consistently returns capital and realizes capital gains to meet its quarterly distribution. To reiterate: The high distribution rate has not bolstered total returns beyond those achieved by ECH.

Second, it is very difficult to find shares of this CEF to sell short; many popular brokerage firms do not keep an inventory of CEFs shares for short sales, and the ones that do tend to focus on the larger, more liquid funds. Otherwise, investors could arbitrage this fund by shorting Aberdeen Chile and buying ECH. Some institutional investors could have an easier time dealing with the logistics, but might find it more trouble than it's worth because of its small size. Efficient markets hypothesis sticklers might point out that this situation does not technically represent a market inefficiency because arbitrage (that is taking a short position in Aberdeen Chile and a long position in ECH) is so difficult. Nonetheless, the best investors can do here is to simply avoid the CEF at its current premium and instead buy ECH if they desire Chilean equity exposure.

PIMCO High Income (PHK)
The Neutral-rated PIMCO High Income has long been a favorite punching bag for journalists and CEF pundits for good reason: This fund routinely trades at one of the largest premiums in the CEF universe, hovering around 50% on April 14. It is also one of the highest profile funds of the CEF market, with a market capitalization topping $1.5 billion. Considering that it is run by Morningstar Manager of the Decade Bill Gross and manages to pay a 17.6% distribution rate at NAV, it's not difficult to understand why this fund is in high demand.

To be clear, this strategy is not suitable for orphans and widows; Gross routinely utilizes the fund's closed capital structure to make concentrated sector bets, take positions with high degrees of duration and credit risk, and use plenty of leverage and derivatives along the way. It's not unusual to see the fund's NAV gains or losses reach double digits in a single quarter, but he has produced impressive absolute returns since taking over management responsibilities in 2009. But despite the value that Gross might add to this high-risk strategy, High Income is simply a bad investment at its current premium.

The most obvious disadvantage of buying this fund is its share price risk. A bad year of performance, a Black Swan event, or a negative article in a popular investment publication could lead to extreme levels of short-term volatility (at best) or permanent capital loss (at worst). For example, High Income went on a tear in 2012, posting a 40% return on a NAV basis. However, shareholders actually lost 1.8% that year because the fund's premium collapsed from its 73% high in August to 24% by year-end.

The high premium also presents another distinct problem: It significantly eats into investors' returns, even if one assumes that Bill Gross will live forever, that he will continue to successfully execute his strategy with no hiccups, and that no negative articles will shatter investor confidence in the fund. PIMCO estimates that the fund is currently earning 16.5% of net investment income at NAV, which means that the portfolio generates an annualized 17.6% in investment income gross of fees (1.06% for fiscal 2013). In other words, the market requires a 17.6% rate of return as compensation for holding the securities in the portfolio. After taking into account fees, the effects of returning capital at a premium, and the premium itself, investors see an earning rate of only 10.6% at share price. This means that shareholders are giving up an annualized 700 basis points of return to hold this fund. Even by hedge fund standards, this is an expensive proposition.

Investors interested in High Income's strategy, but not its premium, might want to consider PIMCO Income Strategy II (PFN). Since a strategy shift in late 2009, this fund has kept a similar asset allocation to High Income and has logged fairly similar NAV total returns. To be sure, Income Strategy II is generally much less aggressive than High Income and has subsequently underperformed it on a NAV basis with lower levels of volatility. However, the key advantage of Income Strategy II is that it currently trades at a 3.3% discount instead of a 50% premium. Investors don't give up much in the way of income either: Income Strategy II's 9.3% distribution rate at share price is in the same ballpark as High Income's 11.7% distribution rate, but the former achieves this with much lower levels of portfolio and share-price risk.

We always recommend avoiding CEFs trading at double-digit premiums as a general rule. There are occasionally exceptions to this rule, but Aberdeen Chile and PIMCO High Income are not exceptions. In fact, these two funds are possibly the worst two CEF deals investors can buy in the current market environment. Not only are both funds incredibly overvalued on an absolute basis, but they stand in stark contrast to more attractive alternatives.

Steven Pikelny does not own shares in any of the securities mentioned above.