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Thread: Three Discounted Funds Yielding Over 9 Percent

  1. Default Three Discounted Funds Yielding Over 9 Percent

    As equity markets grind higher and investors complain about the absence of value, they continue to flock toward cheap and efficient exchange-traded funds (ETFs). Money directed to equity ETFs grew 13% in 2016, pushing the assets under management to $2.4 trillion in the U.S. alone.

    While the ETF growth stampede continues, seemingly ignoring valuations in some cases, an ocean of value is being ignored among the ETF's grandparents: the venerable closed-end fund (CEF).

    I've always had a soft spot for the good old CEF. They tend to fly under the radar. So, before we go shopping, here's a little historical background.

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    CEFs trace their origin to investment trusts organized in Great Britain during the 1860s. The objective was to raise money for investment in the British Empire's colonial possessions as well as to provide capital to the rapidly expanding railroads in the United States. Financed using bank leverage or the sale of debentures, their primary objective was income rather than capital appreciation.

    CEFs gained popularity in the United States during the Roaring Twenties. Prior to the Crash of 1929, CEF assets topped $4.5 billion, a significant chunk of the stock market's total capitalization. But with the market excesses of that period came abuse and corruption, and CEFs weren't immune. The Investment Company Act of 1940 cleaned up the way funds operated, but CEFs remained tainted from the Crash and subsequent scandal. Eventually, they became overshadowed by the seemingly more transparent open-end mutual fund structure we're familiar with today.

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    In the 1980s, top-flight money managers such as Martin Zweig, Mario Gabelli, and Chuck Royce brought credibility and renewed interest to the CEF as an investment choice that offered the value of expert management. Still, the biggest yellow flag to investors was, and still is, the use of leverage inside of CEFs. In low rate environments, 30% leverage can help a manager juice returns. However, rising rates are always the bane of leverage use. Most modern CEFs stick to a conservative maximum leverage percentage as spelled out in their mandates.

    But CEFs still fly under the radar and are ignored by most individual investors. This widespread misunderstanding has created attractive value in the CEF space, primarily in the discount between a CEF's market price and its net asset value (NAV). Here are three unique opportunities in the space.

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    Typically, my interest gravitates towards more diversified choices. However, IRL presents a way for investors to play the impending withdrawal of the UK from the European Union, or "Brexit" in popular terms. 80% of the fund's $73 million in assets is invested in equity and debt of corporations registered on the Emerald Isle. Ireland remains a bright spot thanks to its firm commitment to the EU, economic vibrancy, and participation in the common currency (remember, while an EU member, the UK did not adopt the euro).

    Ireland stands to benefit from Brexit by taking in EU-focused companies who need to relocate. Moving your offices to Dublin is much easier and attractive than relocating to, say, Brussels. The fund doesn't use leverage, trades at a 6.8% discount to NAV and currently yields 8.17% based on a $12.77 share price.

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    Focusing on healthcare with an emphasis on biotech, HQH seeks long-term capital appreciation by investing in companies across the healthcare sector. 40% of the fund's $892 million in assets under management are invested in restricted securities of both public and private companies. This gives shareholders exposure to unlocked value, especially when private goes public. Averaging an 11.17% annual return over the last decade, HQH is an excellent, cutting-edge portfolio to complement Tekla's more conservative offering, Tekla Healthcare Opportunities Fund (NYSE: THQ). HQH shares trade at a roughly 4% discount to NAV at $23.88, and pay a 10.55% dividend yield.

    Risks To Consider: Collectively, the biggest risks facing these three CEFs are rising rates and market perception. Due to the wide use of leverage amongst CEF managers, rate turbulence usually affects the group. Even funds not using leverage get punished in a downturn. That said, the actual effect of rising rates would not come into play as the funds don't employ leverage. It would stand to reason that their portfolios would recover more quickly.

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