February 10, 2016 | by James Behr Jr & Christopher Paleologus
The question we pose to you may seem too good to be true. You may say, “No one would give me $1 for 85 cents.” Allow us to introduce you to closed-end funds (CEFs).
A closed-end fund is a publicly traded investment company that invests in a variety of securities, such as stocks or bonds, just like the more common mutual fund you surely have heard of. The reason behind the name is because unlike open-end (mutual) funds, which are free to issue and redeem shares on demand, CEFs raise a fixed amount of capital through a process known as an Initial Public Offering (IPO). We never recommend purchasing a CEF at its IPO. Once this capital is raised, the fund is closed to new investors and must be purchased in the secondary market.
A mutual fund is bought and sold based on its net asset value (NAV) which is determined at the close of each business day. Closed-end funds however are bought and sold on exchanges throughout the day where their price is determined by investor supply and demand as well as NAV. The market price is based on many factors such as the type of investments the fund holds, performance, overall market conditions, investor appetite for risk, and distribution rates among others. This price is usually different than the fund’s NAV. If this deviation happens to fall below the NAV, it is considered a discounted rate; in contrast, if it rises above, it is considered a premium. Thus, you may have an opportunity to buy $1 worth of a CEF for 85 cents. Investors purchasing CEFs at discounts have various opportunities to make money: First, if the discount narrows over time, and second, if the market price increases in value. Lastly, special situations such as tender offers, rights offerings, or closed-end fund activism, if handled correctly, provide investors opportunities for substantial gains. An important note to remember is that a CEF may trade at a discount forever. The goal though is to purchase the fund at a greater relative discount. For example, a fund may have traded at a 15% discount for the past three years. If that fund was to suddenly increase to a 20% discount this would indicate a greater relative discount all things being equal. The same is true for possible selling opportunities. If the same fund, over the same time has traded at a 15% discount and now decreases to a 10% discount, with all things being equal, it may be a good time to sell because the fund will likely revert back to its average discount.
Provided we like the style and management of the fund, there are several reasons in addition to relative discounts to purchase closed-end funds. Having a fixed number of shares allows for a stable pool of capital whereby the fund manager may remain fully invested if they so choose without having a concern about meeting cash redemptions in falling markets or investing an influx of money in rising markets. CEFs, because of their stable capital structure, are therefore able to invest and benefit from longer-term ideas. Investors have the ability to choose from some of the top money managers in the business. Closed-end funds generally offer investors regular cash flows in the form of monthly or quarterly dividends that are usually more generous than those of mutual funds. CEFs can take advantage of favorable rates allowing the fund to leverage their investment positions through the issuance of debt or borrowed money providing enhanced yield and total return. This of course is a double edge sword and can be detrimental in falling markets. Closed-end funds also have the ability to opportunistically buy back shares when wild deviations from NAV occur. One of the major pitfalls of mutual funds is the fees. Closed-end funds do not incur all of the same ongoing costs that mutual funds do, generally resulting in lower fees, which over time should increase your returns.
In summary, CEFs allow you the potential to invest in stocks or bonds at a discount from NAV. We believe this benefit can provide tremendous long-term value to investors of all ages.