Closed-End Funds vs ETFs
Closed End Funds (CEFs) often trade at a discount to NAV. The catch is that generally, the ongoing management fees are more expensive. With some foreign markets though, accessing an active fund manager may produce better results than merely tracking the index.
The argument is some overseas markets are less efficient and the benchmarks do not provide a good portfolio. This could add to the case for CEFs versus some passive ETFs. There are also the chance activist investors take steps to narrow the discount to NAV. This has been a trend over the last couple of years.
Using the CAPE ratio to find value
The CAPE ratio can be a useful tool for long-term investors. It can provide some perspective on return expectations of various global markets when thinking in terms of the next decade. The below chart suggests it may be worthwhile to look outside of the US:
Below I shall examine three CEFs focused on offshore markets that are worth consideration.
The China Fund, Inc. (NYSE:CHN)
This fund is managed by RCM Asia Pacific Limited and has a baseline expense ratio of about 1.4%. They concentrate on obtaining exposure to China via the H shares market in Hong Kong. Historically H shares have traded at a discount to their equivalent A shares that are listed on the Chinese stock exchanges.
This currently remains the case, so I see this as a better opportunity than direct exposure to the Chinese stock markets. The discount to NAV for this fund has tended to be around 8% over the start of 2018. Over the last few years it is not uncommon to see a discount in the order of 10-15% though in this fund.
China – Simple But Promising
Sometimes I think it is better to keep investing as simple as possible. China is still one of the faster-growing economies in the world today. Most of us will one day see it overtake the US as the leader in global GDP. Lets first take a glance below at how world stock market indices have evolved over the last century.
We can barely see China as a market that many international investors consider. Surely eventually we can expect China to make up a larger share in the world stock market indices. Recent years has seen investors embrace passive investing and follow popular benchmarks. This looks likely to strongly favour China one day in the future.
Whilst the US market has plenty of exposure to technology, investors are becoming increasingly familiar with Chinese technology names. Tencent and Alibaba are names you will find in this fund. The forward P/E of the whole portfolio will be substantially cheaper than you are likely to find in the US market.
The Hang Seng China Enterprise Index (HSCEI) has significantly underperformed the S&P500 since the last global bear market in equities. Now might be the time to consider switching some exposure from US to China. Over the long term I expect that many funds will be doing the same. This may merely be to follow the natural course of where global equity benchmarks are heading.
Korea Fund, Inc. (NYSE:KF)
Despite all the noise about geopolitical risk, the South Korean share market was one of the globe’s star performers in 2017. Yet even after excellent gains, the CAPE ratio sits around half that of the US. Another value measure that indicates modest expectations there are the low price to book ratios many companies trade on.
Part of the explanation of cheaper valuations may rest with perceptions of poor corporate governance. Dominant shareholders taking advantage of minorities can be a concern. Some signs have been evident that these issues can be addressed by lifting dividend payout ratios, as reported here.
Samsung As A Benchmark
A foray into the South Korean market shouldn’t be considered without thinking about Samsung. This Korea Fund has about a quarter of the assets invested in Samsung. This is not that much out of line with the benchmark though. Without discussing Samsung in depth here, we can at least say that the company looks cheap on many fundamental quantitative measures.
It does remind me a little from when we were saying the same about Apple shares only a couple of years ago. Plenty of analysts cited reasons why this cheap valuation would persist. Yet it didn’t stop Apple stock from almost doubling from this low point.
Many investors shy away from the South Korea market because geopolitical tensions often make front page news. My experience tells me though when such risks are front and centre, it often removes the “weak hands” in the market. If the worst fears do not come to fruition then this can lead to sharp rallies. We witnessed some of this in 2017.
2018 will keep the trend?
It wouldn’t surprise me if 2018 proved to be a similar story, and the Korea Fund might be a good way of obtaining exposure to this theme. It is managed by Allianz Global Investors Capital, has baseline management expenses of approximately 1.2%. Over the last year the fund has regularly traded at a discount to NAV of greater than 10%.
When suggesting this fund for potential exposure I wouldn’t turn a complete blind eye to the geopolitical risks I have referred to. That may just mean it can still stack up well on a risk /reward basis, but admittedly have more tail risk than other markets. It therefore could be one to consider a smaller position size compared with other broad market exposures globally.
The Central and Eastern Europe Fund, Inc. (NYSE:CEE)
The Central and Eastern Europe Fund would be another one that I would consider having a lower exposure than to other markets. Its price has come to life in early 2018 but its history suggests it can make powerful moves. It has been volatile, so I am speaking of large moves whether that be up or down! For that reason, it may be a fund to consider running a stop loss on. It can give yourself a chance to participate in a strong move but with some risk management in place.
Low CAPE Ratio, Cheap Investments
In terms of the CAPE ratio, things don’t come much cheaper than this. The fund carries nearly two thirds of its assets in Russia. The Russian market was recently showing a CAPE ratio of only 6 times! When you mention Russia as an investment destination you may well be met with a flabbergasted look. It typically won’t be met by rosy forecasts of the economic outlook.
Yet I find sometimes great investment returns can be obtained by paying dirt cheap valuations for an asset. On the other hand, investing where the news appears excellent can be riskier. There is a saying in the markets that you pay a high price for certainty. The opposite is the case here, uncertain views from the market is providing extremely cheap valuations.
Part of what has sparked interest in this fund early in 2018 has been a pick up in energy prices. Let’s examine how the Russian economy faired over the decade up to when the oil price bottomed in late 2015.
We can certainly see some correlation here. If the oil price was to be able to get back near the $80 level it would be significant. Then there is good potential for a further major positive rerating for the Russian share market.
Not Only Russia
This fund is not entirely a pure play on Russia though. The other third of the fund is invested across Eastern Europe, with 20% exposure to Poland. The fund is run by Deutsche Investment Management and has tended to trade at a discount to NAV of about 12%. The baseline management expenses are approximately 1.4%.
Last year they made some changes to the mandate hoping to assist in the narrowing of this discount. The name changed from when it was formerly known as the Central Europe, Russia and Turkey Fund. They also stipulated that at least 80% of the fund must be in issuers domiciled in Central and Eastern Europe. There is now a minimum of 25% of assets that must be placed in securities within the energy sector.
Picking certain individual pockets in emerging markets like this is no easy task. When the valuations in the US appear so high though, it warrants some investigation. The answer could lie in selecting a basket of foreign markets, and carefully allocating only what you are comfortable with. Larger drawdown risks though must be accepted as you get further towards the emerging markets part of the spectrum. Some well-respected investors subscribe to the theory of a “melt up” in markets occurring in 2018. These type of emerging market exposures may be worth the risk to play this theme.