Notes
How do you know if a cheap stock is a good value, or cheap because it is bad? If you understand the business very well, you can do your own research. A lazier and more common method is to check the opinions of people who should know, such as analysts and insiders.Closed-end funds (CEFs) often trade at a discount, providing a quick way to find seemingly cheap stocks. They usually aren't followed by analysts, however. They also charge fees, which can undermine their cheapness.
I've been testing a system for trading CEFs that aims to find cheap CEFs while avoiding those that are cheap because they have problems. The system has two parts. First, it requires recent insider buying. CEFs usually aren't followed by analysts, so insider trading provides the qualitative indication of the health of the fund. Second, it divides the discount (as a positive number) by the fees. The discount/fee ratio shows whether the stock is cheap (bigger is better).
I've tracked the performance of this system at Marketocracy for over 2.5 years. In that time, it has outperformed the S&P by an annualized 14%, with a turnover rate of around 50%. It is a simple and low-labor trading system.
Performance statistics for the fund are on the fund's public page:
http://www.marketocracy.com/cgi-bin/WebObjects/Portfolio.woa/ps/FundPublicPage/source=JdBhGmFlEcPcImClMaKiAbDd
The Marketocracy fund is not a purely mechanical implementation of the system: I don't automatically buy the CEFs with the highest discount/fee ratio or most insider buying. I look at diversification and use my own judgment of what type of investment will do best. The fund never holds CEFs with a discount/fee ratio below 5 and no recent insider buying, however. Note that Marketocracy's performance figures include fees.
Here is a list of some CEFs that currently qualify as buys in this system. I've included the Morningstar rating when available, although that's not a part of the system I've been testing. the "Insiders" score is my rough and somewhat subjective estimate of the strength of recent insider buying (3 is best).
http://seekingalpha.com/article/66789-a-system-for-trading-closed-end-funds
3AUG08 - update
The test-fund continues to outperform the S&P 500, beating the index by 3% in the last 6 months.Perhaps the most interesting feature of the system is what I think of as the Return on Sweat-Equity [ROSE]. The ROSE is the ratio of your returns to how much work you have to do to get those returns. Buy-and-hold investing requires a low investment of sweat-equity, whereas day-trading requires a lot of sweat-equity. If the returns are the same, then buy-and-hold will have a higher ROSE. Pretty simple.
This system for trading CEFs has a pretty high ROSE. Typically, I check the portfolio once a month or less. The beta (volatility) is usually below 1 and the annual turnover is around 50%. Those of us who enjoy investing, but do other stuff like hold jobs, are interested in beating the market on a few hours a month.
Coincidentally, the top buy of the Marketocracy gurus in the last week is SWZ--a CEF specializing in Switzerland. It qualifies as a buy in this system as well. Here's a current list of some (not all) CEFs that have high discounts relative to their expense ratios (fees), and recent insider buying. IÕve included the Morningstar rating when available, although it isnÕt part of the system.
http://seekingalpha.com/article/89125-trading-closed-end-funds-an-update
Investing in funds tends to use a "top-down" or macroeconomic approach to investing, and this is no exception. That is also conducive to earning a high ROSE, as one can ÒresearchÓ some macroeconomics simply by keeping up with the daily news.
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