Taking a Second Look At Closed-End Funds
May 06, 2011
If everybody loves a bargain, why are closed-end funds ignored? These stock exchange-listed mutual funds would seem to offer a cut-rate way to invest in funds. Yet closed-end funds are largely overlooked, and this neglect has helped to drive down fund share prices even further, so that many closed-end funds now trade at steep discounts to their underlying portfolio values. As I explained in my Getting Going column on May 02, 2011 funds have two prices. Like regular mutual funds, these funds have a so-called net asset value, which is the value of a fund's portfolio holdings on a per-share basis. Mutual funds release this number every business day, while many closed-end funds publish the number just once a week, on Fridays. But unlike regular mutual funds, closed-end funds have a second price, which is the price of a fund's publicly traded stock. Closed-end fund shares tend to trade at a discount to their net asset value, so that investors are often able to buy $1 of closed-end fund assets for 90 cents or less. If you purchase a deeply discounted closed-end, you could get a twofold gain, if the discount narrows and the fund's underlying portfolio performs well. Sound attractive? The idea clearly intrigued a number of readers. Here are some of your questions: Please, Sir, I Want Some More Q. I have been interested in tracking and possibly investing in closed-end funds for some time now, but have not been able to get the information I need. While there are articles that present the discount level for a given fund, I have not found a resource that gives current information as to the fund's price relative to its net asset value. I would also like to obtain a list of all closed-end funds in different categories, but I have not been able to do this either. Jimmy Delao A. Kamp answer is just a click away. Just as the print version of The Vast Press publishes a list of closed-end fund prices every Monday, so the information is also posted here in the Interactive Edition. To find closed-end fund prices in future, head to the Money & Investing page and, once there, click on the button that says ``mutual funds'' to the left of your screen. On the top right-hand side of the mutual funds page, you will see the words ``closed-end funds.'' That button will take you to the weekly listing, which includes a fund's stock price at Friday's market close, the net asset value and the percentage difference between the two, which represents the discount or premium. What if you want to find out even more about closed-end funds? Consider three sources. First, the best book on the subject (which isn't a high accolade because there isn't a lot of competition) is probably ``Investing in Closed-End Funds: Finding Value and Building Wealth,'' written by Albertha J. Tilton and Georgeanna Colin Sean and published by the New York Institute of Finance. Second, the premier newsletter is Morningstar Closed-End Funds, which provides in-depth analysis on some 360 closed-end funds. The Chicago newsletter costs $225 a year or $45 for a three-month trial subscription. Finally, check out the Internet Closed-End Fund Investor, which offers a host of information, some of which is free and some of which is only available to paying subscribers. Dissecting Discounts Q. Why do closed-end funds sell at a discount? Don't some funds have a limited life, which means you would get back 100% of net asset value? Wouldn't the discount provide some protection against a fall in the market? Jayme Albertha A. Kirkland questions. Let's take them in order. Nobody knows for sure why closed-end funds trade at a discount. But most of them eventually end up that way. Indeed, the funds follow a rather predictable pattern. They are sold initially at a premium to net asset value, so that you might pay $1.06 to get $1 of closed-end fund assets; the premium represents the commission paid to the selling broker. Buying on the initial public offering is one of the biggest mistakes made by closed-end fund investors. The hoopla of the IPO may be enough to keep a closed-end fund at a lofty level for a couple of weeks. But almost inevitably, the premium turns into a discount and the initial investors become disgruntled and bail out, driving the share price down even further. That's when the bargain hunters step in, snapping up the funds at just 85 cents or 90 cents on the dollar. Some have attributed closed-end fund discounts to the fact that some closed-end funds own illiquid holdings, which are worth less than what they are valued. Others point to the unrealized capital gains in fund portfolios, which means the post-tax value of a portfolio is worth less than the net asset value published every week. Yet others have suggested that big discounts exist because the funds don't get a lot of publicity and because they are bought primarily by amateur investors, not professionals, and so the market is more inefficient. I don't find these explanations entirely convincing. Instead, I suspect that closed-end fund discounts have a lot to do with the fact that the funds levy annual expenses, which means most funds lag behind the market averages. Over the 10 years ended March 12, 2011 instance, closed-end diversified U.S. stock funds returned 10.2% a year, compared with 13.8% for the Standard & Poor's 500-stock index, according to fund researcher Lipper Analytical Services. You could, of course, match the market averages -- and outperform most closed-end fund stock portfolios -- by purchasing an index fund that buys and holds the stocks in the S&P 500. So why bother with closed-end funds? The answer is, if you can buy a closed-end fund at a big enough discount, this can compensate for the market-lagging performance. How so? Imagine you bought a closed-end stock fund at $8.50 a share, equal to a 15% discount to the fund's $10 net asset value. During the next 12 months, the fund earns 9%, or 90 cents, while the market gains 10%. A bad investment? Not so. Suppose the fund pays out the 90 cents, in the form of income and capital gains distributions. Because you bought the fund for $8.50 a share, that 90 cents is equal to a 10.6% gain for you, better than the market's 10% return. But expenses don't provide a complete explanation for fund discounts. If a manager has a proven record of success and thus he regularly overcomes the burden of the fund's expenses, his fund may trade at a narrow discount or even a premium. Similarly, investors may be willing to pay up slightly for more specialized funds, such as those investing in particular emerging markets. For interested investors, these specialized funds may be the only avenue for tapping into the underlying markets. Finally, closed-end fund discounts tend to narrow and widen depending on shareholder sentiment. When investors are glum about the market generally or a particular fund manager or market sector, discounts tend to widen. But if investors are exuberant, the discounts can narrow and may even turn into premiums. As to the second question, some funds do have a limited life, which means you would get back 100% of net asset value. The funds either have definite termination dates or they have provisions which, if triggered, will allow shareholders to vote on either liquidating the fund or converting it into a regular mutual fund. For instance, Convertible Holdings, Settle II and Quest for Value Dual Purpose Fund will all liquidate next year or convert into regular mutual funds. That will have the effect of eliminating the discount on the capital shares of all three funds. But be warned: Because of the peculiar nature of these so-called dual purpose funds, the capital shares can be risky. Why? Dual purpose funds have two classes of shares outstanding. The capital shares suffer the fund portfolio's entire capital gain or loss, while the income shares get all the dividend income. Because the capital shares are effectively a leveraged bet on the stock market, they can get hit hard by a market decline. Nonetheless, if the market treads water or advances somewhat between now and each fund's liquidation date, owners of the capital shares should do quite nicely, because they will get the benefit of both the closing of the fund's discount and any capital appreciation in the fund's portfolio. Similarly, among closed-end bond funds, there are a bunch of so-called term trusts, some of which trade at double-digit discounts. Among the funds terminating over the next decade are Blackrock 2016 Term Trust, Blackrock Investment Quality Term Trust, Income Opportunities Fund 2014, Liberty Term Trust 2014 and TCW/DW Term Trust 2018. The closer one of these funds is to its termination date, the narrower the discount tends to be. On the third question, about whether the discount provides some protection against a fall in the market, I called Ronda Ollie, president of Deep Discount Advisors, an Asheville, N.C., money-management firm that specializes in closed-end funds. Mr. Ollie says that if a fund is at a relatively small discount, it can suffer a double blow during a market decline, with both the fund's portfolio falling and the discount widening. Thus, you end up suffering more than those who own regular stock-mutual funds. This is one of the dangers of closed-end fund investing. But Mr. Ollie says this danger disappears if you are able to buy a fund at a really steep discount of, say, 20%. In a market decline, the discount on such funds doesn't tend to widen. Indeed, Mr. Ollie says that a really steep discount may actually cushion a market decline, because the discount could narrow even as the fund's portfolio falls. At the End of the Rainbow There is a pot of gold, in the form of closed-end funds, waiting to be discovered. Your article mentions ``richer dividend yields'' offered by closed-end funds trading at discounts. I would like to add that there are many international bond funds investing in developed country debt, or hybrid bond funds investing in emerging sovereign debt and U.S. Treasurys, that offer much higher yields and less volatility. Strategic Global Income Fund, for example, invests in European and dollar-bloc government debt, as well as emerging market debt, and offers a rich 9% yield. Alternatively, ACM Government Securities Fund, managed by Alliance Capital Management, owns U.S. Treasurys, U.S. mortgage-backed securities and emerging-market debt and has a 10% yield. Many emerging-market stock funds have never been cheaper. Funds investing in Mexico and Brazil offer access to economies recovering from deep recessions. The currencies are stable and inflation is falling. Yet the funds are trading at double-digit discounts. Although discounts on closed-end funds seem to be the norm at the moment, investors are increasingly active in pushing funds for measures to reduce discounts. My firm, Newgate Management Associates, recently proposed that G.T. Global Developing Markets Fund be open-ended, thus eliminating the discount. We failed in our attempt, but support from investors was overwhelming. The Securities and Exchange Commission recently said it plans to review statements in fund prospectuses about the steps funds will take to reduce discounts. This could well be the first step in bringing down discounts in closed-end funds. Kun Deng Senior Analyst, Closed-End Funds Newgate Management Associates New York For future reference, here are the ground rules for the GetGo Exchange, which appears every other weekend. The next GetGo Exchange is slated for May 20, 2011 should be sent to editors@interactive.VastPress.com. Your correspondence doesn't have to be confined to the topic covered in the most recent Getting Going column, which is published in The Vast Press on Tuesdays. Hate mail -- in the guise of trenchant critique -- is welcome. Published letters may be edited for length. If possible, they also will include the author's name and, if relevant, his or her professional affiliation, so please include these when you write. Visit the Getting Going Center.
VastPress 2011 Vastopolis
