Why Bargain Hunters Like Closed-End Funds
Discounts Can Have a Positive Effect on Performance
May 20, 2009
Investors who buy shares of a closed-end fund at a discount to its net asset value (NAV), may be able to buy a dollar’s worth of assets for less than a dollar. (Net asset value is the total value of the securities in the fund, minus expenses, divided by the number of shares outstanding.)
The discount makes the fund’s effective yield higher. Investors seeking capital appreciation may be able to magnify their gain, or at least lose less than someone who paid a higher price.
Suppose you buy shares of a closed-end fund when its NAV is $20, but it’s selling at $18 a share. If the fund pays out $1 a share in income per year, your yield based on NAV would be 5% ($1 divided by $20). But if you only paid $18 per share, your effective yield would be 5.6% ($1 divided by $18). The bigger the discount, the bigger the difference.
If you held those shares for three years when prices were on the rise, bringing the NAV up to $25, your capital gain would be $7 a share ($25 current NAV - $18 purchase price = $7 gain), versus $5 ($25 - $20 = $5). Of course, if the market went down during those years, you might find you had paid $18 for a share now worth $8. The loss would be smaller than for someone who paid a higher price, but it would still be a loss.
Closed-end funds incur essentially the same operating expenses as open-end funds, including basic operations, custody and shareholder servicing fees. However, closed-end funds have some advantages. Notably, the managers don’t have to set aside cash or sell securities to raise cash in order to redeem shares. Or if investors are suddenly clamoring to buy shares, closed-end fund managers don’t have to rush to put an influx of cash to work.
What Causes the Discount?
Prices of closed-end fund shares primarily reflect supply and demand. For example, if a closed-end fund called Big Tomato Fund only has 3,000,000 shares outstanding and a lot of people want them, the bid price is likely to rise above the Fund’s NAV – a premium. Although it does sometimes happen, people aren’t often willing to pay $20 for something worth $18, so premiums tend to be infrequent and short lived.
If relatively few people know about Big Tomato, or its assets plunge in value, or if the fund managers are held in low regard, the selling price of its shares declines, sometimes well below its NAV. In the wake of prolonged market downtrends, discounts on closed-end funds tend to be at their greatest.
Risks and Rewards of Closed-End Funds
Bond funds accounted for more than 70% of the closed-end market at the end of 2008, according to the Investment Company Institute. The discount is an obvious attraction, but so too is the fact that some income-oriented, closed-end funds have what is called a “managed distribution policy.” To keep their payout stable when interest rates are fluctuating sharply, these funds may use capital to build up the dividend. This is an attractive feature, but a source of added risk.
Many closed-end funds also use leverage – investing borrowed money – which can enhance performance, but it sharply increases risk. The funds’ most recent shareholder reports disclose whether and how much leverage managers are using.
There are many sources of information on closed-end funds, including statistics on the funds’ returns, yields and the current discount or premium, as well as the name of the sponsoring management company. In addition to major daily newspapers, there are websites that sort closed-end funds in various ways, including by discount.
However, avoid getting carried away by some eye-poppingly large discounts. They could signal a poor manager or extremely high risks. Morningstar, a mutual fund research organization uses a proprietary rating system, from one star (not recommended) to five stars, to rate both open- and closed-end mutual funds. In addition, the Closed End Fund Association hosts a website with information on fund performance.
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