Saturday, November 12, 2011

Using Z-Scores: Buying Closed-End Funds, Part 2

Since the time of my last writing, a little over a week ago, the market has switched its obsession from Greece to Italy. Wall Street is worried that with Italian bonds trading at extremely low prices, their yields are too high (7 percent) to make future borrowing from the market using bonds practical. Since the swoon Wednesday, Italian bond markets have recovered, probably because of the European Central Bank (ECB) purchasing them, even if indirectly through European banks, which will eventually make Wall Street traders even more nervous than they usually are (and by that I mean petrified), when Italy, like Greece, eventually must default and the European banks are forced to write down all of their losses and recapitalize. Sound familiar? That's exactly what the U.S. endured in the fall 2008 and 2009 unpleasantness, from which we as a country have never really recovered.

Wednesday I bought some MGM Resorts (MGM) at about $10.00, and during the past few weeks I have been buying the closed-end funds Wells Fargo Advantage Global Dividend Fund (EOD) and the PIMCO Corporate Opportunity Fund (PTY), the former boasting a 13 percent dividend yield and the latter sporting about a 7.5 percent yield. Closed-end funds (CEFs) can trade at a discount or a premium to net asset value (NAV), that is, the value of the assets underlying the shares. For example, EOD is currently trading at about a 7.5% discount to NAV, and with its high yield, I find it a promising addition of my (nearly) permanent portfolio.

Unlike EOD, PTY almost always trades at a premium to NAV. Currently, the fund's premium is 22.68%, and, therefore, you are paying 22.68% more to own the fund than it's worth. Now usually overpaying for an asset is not my style, especially overpaying for CEFs, even one like PTY with a nearly 8% dividend yield, because many CEFs routinely trade at a discount to NAV. Why not just pick a different, cheaper CEF? In the case of PTY the fund almost always trades at a premium to NAV. In fact, according to, PTY's NAV has ranged between a discount of 2.17% and a premium of 29.49% during the past year; however, PTY only traded at a discount to NAV briefly. The question remains: How are we to judge whether a CEF that is trading at a premium already is overbought and too expensive? The answer: statistics.

Now we're going to get a bit technical, so hold on. PTY's one-year z-score is currently 0.94, according to In this case, the one-year z-score = (current discount - average discount)/(standard deviation of the discount) computed with data from a year ago to today. Now if your statistics is a little rusty, let me sum it up for you with the following statement: under certain conditions, we expect PTY to trade at a premium of 22.68% or more only about 17 percent of the time. That's a little alarming; the percentages do seem to suggest, then, that the fund is too expensive, if we ignore the 7.5% annual yield that we are paid in the form of a monthly dividend.

Here's a one-year chart of PTY: on dips I'll buy some more.

Truth is that my average purchase price on shares of PTY is $17.12 compared to its current trading level of $17.85; in fact, I bought the my shares when PTY's premium was much lower and the one-year z-score was close to 0, which means that I bought by shares when the fund traded at about its average premium over the past year. I plan to hold on to my shares of PTY until the fund gets obscenely overvalued at around $20, which may happen sooner than you think with so many investors grasping so desperately for yield. I will buy more if PTY drops below $17, and especially $16, again, which may happen as the markets swoon anew if the Italians or the Greeks don't dance precisely the way Wall Street wants them to while they try to reduce what is perceived as profligate European spending.     

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