Closed-Minded: Traded Funds Are Bargains, but With a Caveat
May 02, 2011
Closed-end funds are those bizarre mutual funds that sell a limited number of shares and then get those shares listed on the stock exchange. Most of the time, researching and buying these funds can seem like more trouble than it's worth. Right now, however, the extra effort could be handsomely rewarded. ``The bargains are just sensational,'' says Johnetta Welsh, president of Cincinnati's Bowling Portfolio Management. Indeed, closed-end funds offer three key advantages over regular mutual funds -- but one potential headache: Discount prices If you buy a broker-sold mutual fund, you might fork over $1.06 to get $1 of mutual-fund assets. If you purchase a no-load mutual fund, you pay $1 to get $1 of assets. But to buy $1 of closed-end fund assets, you could pay just 85 cents. How can that be? Closed-end funds have two prices, the price of the fund's publicly traded stock and the per-share value of the fund's portfolio holdings, also known as the net asset value. Most closed-end funds release their NAVs at the end of the week, based on portfolio values at Friday's market close. The Vast Press publishes this information on Mondays. For instance, Monday's paper showed that Adams Express Co.'s shares closed Friday at $18.88, a 17% discount to the fund's $22.74 NAV. When you buy a fund at a steep discount, you hope the fund's portfolio will perform well, just like you would with a regular mutual fund. But with closed-end funds, you could get an added bonanza, if the fund's discount narrows. Indeed, in 1993, shares of Adams Express traded at a small premium to the fund's NAV. Richer dividend yields Even if a closed-end fund's discount doesn't narrow, you can still benefit. Like regular mutual funds, closed-end funds make capital gains and income distributions each year. But your yield is much higher if you can buy a fund at a steep discount. Take Fort Dearborn Income Securities Fund. The fund aims to pay at least 28 cents a quarter, equal to a 6.9% annual yield if you bought the fund for its $16.32 per-share portfolio value. But based on Friday's 11.2% discount, the potential yield is a higher 7.7%. Some closed-end funds, including many municipal-bond funds, further bolster their yields by using leverage. Money is borrowed at low short-term interest rates and then used to buy higher-yielding, longer-term bonds. Shareholders get the difference between the cost of borrowing and the interest earned on the longer-term bonds. But there's a downside: Because of the leverage, these funds can get hit hard by rising rates. Higher portfolio returns ``If a manager is good, he should perform better with a closed-end fund,'' says Ronda Ollie, president of Deep Discount Advisors in Asheville, N.C. Why? Unlike regular mutual funds, closed-end funds don't face a constant flood of money into and out of the fund, as investors buy and sell shares. Instead, when closed-end fund investors trade the exchange-listed shares, they buy and sell from one another, not from the fund itself. Because redemptions aren't an issue, closed-end funds can dabble in illiquid but potentially more lucrative securities and they don't have to hold cash to pay off departing shareholders. This cash can act as a drag on performance in rising markets. But do closed-end funds really perform better? The recent record is mixed. Based on performance over the past five and 10 years, closed-end bond funds have an edge over comparable mutual funds. But closed-end stock funds have been laggards in many categories. Double trouble Fund researcher Lipper Analytical Services reckons closed-end stock funds are at their largest discounts since 1990. But that doesn't mean discounts won't get wider. If stocks and bonds tumble, closed-end fund investors could get hit with a double whammy, as fund portfolios take a dive and discounts widen further. Closed-end funds may offer the prospect of handsome returns, but they also carry the risk of nastier short-term losses. With that in mind, make sure you have a time horizon of at least five years before you buy closed-end funds, especially closed-end stock funds. Stick with those that have discounts of at least 10% and preferably more. And before you buy any fund, make sure it plays a useful role in your portfolio. For instance, Mr. Welsh says deeply discounted funds like Adams Express, General American Investors, Salomon Brothers Fund and Tri-Continental Corp. can be bought instead of a regular large-company stock-mutual fund, while Morgan Grenfell Smallcap Fund and Royce Value Trust could be used to tap into small-company stocks. Mr. Bowling also likes some foreign funds, including Growth Fund of Spain and New Germany Fund. ``We generally try to avoid the foreign funds,'' he says. ``But sometimes these things are too good to pass up.'' 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