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Profit from Tax-Loss Selling
with Closed End Funds |
Published:
December 9,
2007
Year-end tax-loss selling makes this a great time of year to scout out
some real bargains on closed-end funds.
A recent study in The Journal of Finance found that many
closed-end funds tend to sell off in the last few weeks of the year and
then rally in January. The reason for this seasonal behavior is that
tax-sensitive investors often sell funds at a loss late in the year to
help offset capital gains elsewhere, lightening their overall tax load.
Heavy year-end selling can drag a fund's market share price below its
net asset value (NAV) -- the value of the underlying securities in the
fund's portfolio. The resulting discount can create an attractive entry
opportunity. For example, if a fund is trading at a -20% discount, then
you'll only be paying $80 for a $100 worth of assets.
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Right now, over 80% of the 701 closed-end funds listed by the
Closed-End Fund Association are trading at a discount to their
underlying assets, and yet some of these same funds have seen their
portfolios grow by as much as +400% over the past year.
Come the new year, the so-called "January Effect" should kick in. Funds
that are cast off in the last few weeks of 2007 may soon look enticing,
as tax loss selling will artificially depress share prices and push
yields higher (Share price and yield move inversely). If history is any
guide, then bargain hunters will swoop in during the first few weeks of
January, bidding up the share price of many beaten-up funds.
Some closed-end funds make better candidates for this strategy than
others. According to The Journal of Finance study, municipal bond
funds tend to work particularly well because owners of these funds are
typically focused on taxes. Take MFS High Yield Municipal Trust (AMEX:
CMU), for instance. Last November, it was trading at a modest -0.3%
discount to its underlying portfolio assets. In December, that discount
had widened to -1.0%. However, by January the fund was trading at a
premium of +1.9%.
Thinly-traded funds with 50,000 shares or less in average daily trading
volume also work well. Over the past three months, only about 39,000
shares of CMU have changed hands on an average trading day. Low trading
volume tends to exaggerate price swings, so when investors flock to the
exit doors in the weeks before December 31st, they'll move a fund like
CMU far more than they would a larger, more liquid fund.
New funds that were issued earlier in the year also make good prospects
for this strategy. New funds are typically issued at a premium to their
portfolio value because the initial share price includes a fee to the
underwriter. These fees can represent as much as 8% of the fund's net
asset value. It usually takes a few months for the share price to back
off and move closer to NAV, or even below it.
For instance, a fund may come to market in July at a +5% premium to its
NAV, but trade at a discount sharp discount just a few months later in
November. If this were the case, we would expect to see that discount
widen even further as tax-loss selling drags down the share price prior
to the start of the new year.
One caveat: Tax-loss selling at year-end can provide a great entry point
for fundamentally-sound funds, but if you hold your assets in a taxable
brokerage account, then you may want to time your buying to avoid
another year-end tax issue -- capital gains. Most funds pay out their
year-end capital gains distributions sometime in November or December.
For example, the Nicholas-Applegate Global Equity & Convertible Income
Fund (NYSE: NGZ) has announced a distribution of $0.64 per share,
payable December 28th. You may be tempted to capture this distribution,
but first you should weigh the consequences.
Once the fund goes ex-distribution on December 14th (meaning it trades
without the right to receive the dividend), the price of the fund will
drop by about the same amount of the payment. NGZ is currently selling
for $21.50 per share. On December 14th, it will likely open at about
$20.85 a share.
While full details have yet to be released, at least some of the
distribution will likely be taxable at the 15% capital gains rate. So if
you bought the fund pre-distribution, then you would soon see the share
price dip by around $0.65, and you would also be on the hook for the
capital gains taxes associated with the payment. With this in mind,
tax-sensitive investors may wish to avoid the tax bite by buying after a
fund goes ex-distribution and entering at the lower price.
Action To Take ---> Below we have
listed some closed-end funds that have gone public at a premium within
the last few months. They have already started to fall back near or
below their net asset value and could drop even further on tax-loss
selling.
Important Note: Throughout the
remainder of this article,
High-Yield
Investing editor Carla Pasternak provides a list of funds
that should soon see a pop, thanks to the "January Effect." In addition
to these potential gains, each one also yields at least 7.5%, and eight
carry hefty yields of more than 10%. However, in order to view the
remainder of this article, you'll need to subscribe to our premium
income investing newsletter --
High-Yield
Investing. After you subscribe, you'll receive immediate
access to this full article, as well as our monthly
High-Yield
Investing newsletter and a host of additional premium
content. Please visit one of the following links to continue.
Good investing!
Carla Pasternak
Editor
High-Yield Investing
http://www.StreetAuthority.com
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Carla
Pasternak draws on a variety of financial backgrounds to make profitable
calls on income-generating stocks for her readers.
Carla has
been employed in the investment industry for more than two decades. In
addition to her work as a writer for several other nationally recognized
financial publishers, her previous experience includes a position as
President of a well-respected investor relations firm. She has also been
writing shareholder reports for public companies (annual reports,
speeches, corporate profiles, slide shows, etc.) since 1980.
A highly
successful investment analyst, Carla specializes in high-yield,
income-paying stocks. In that pursuit, she's always mindful to select
companies that not only pay rich dividends, but that also have the
potential to deliver strong long-term capital gains.
On the
educational front, Carla holds both MBA and Ph.D. degrees. When she's
not watching the market, she's teaching business courses at the college
level and managing several million dollars in portfolio assets.
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