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Mutual funds are often the main component of an advisor’s asset allocation because of their instant diversification.
An Alternative to Mutual Funds
Mutual funds are often the main component of an advisor’s asset allocation because of their instant diversification. What if there was an alternative to mutual funds that provided the same type of diversification? And, would you be interested in purchasing this alternative at a discount?
Mutual funds are priced at what is called Net Asset Value (NAV) per share, which is determined by adding up all the assets, subtracting the liabilities and expenses, and then dividing that by shares outstanding.
When you purchase a mutual fund, the fund creates and issues new shares. Alternatively, when you sell a mutual fund those shares are redeemed. This is the reason they are also referred to as open-ended funds.
Closed-End Funds
A closed-end fund (CEF) is also a pool of assets that is managed by an investment manager. The main difference is that a closed-end fund has a fixed number of shares outstanding and is traded on an exchange, like a stock. Because of this, CEF’s can trade independently to their net asset value.
This means that CEF’s can be purchased at a discount to their NAV in the open market. In simpler terms, if a fund is trading at a 10% discount, a fund worth $1.00 can be purchased at $0.90. One of our top holdings in the CEF space is Adams Diversified Equity (ADX). Below, on the top table are the top 10 holdings of ADX and on the bottom are the current and previous discounts.
Relative Discount
We don’t want to purchase a CEF just because it is trading at a discount. Instead, we want to buy when it trades at what is called a “relative discount”. If I told you that the above fund (ADX) was trading at a 10% discount, is that good value? Well, what if on average ADX trades at a 15% discount? Then it may not be a good value. Conversely, if ADX was trading at a 20% discount when it normally trades at 15% then it may appear to be a good value.
Yield Advantage
On top of being able to purchases these funds at a discount, CEFs offer what is called the yield advantage. Here is an example of how this works:
A CEF and an open-ended mutual fund both have a NAV of $10.00. The CEF is trading at a 10% discount so we can purchase it for $9.00. At the end of the year, both investments pay a $0.90 distribution. Because we purchased the CEF at a discount for $9.00, the yield on this investment is 10% versus the 9% yield on a $10.00 mutual fund.
So, why don’t more investors or advisors use closed-end funds in their investment strategy? Well there are a few reasons that these are often ignored.
CEF’s can be a bad investment
Believe it or not, CEF’s can be a terrible investment if you don’t know what you’re doing. For instance, buying a CEF at a premium or purchasing a CEF IPO is something that should never be done. You can read about more mistakes made when purchasing CEFs here.
Small market
The Closed-end fund market is significantly smaller than the mutual fund market. Which means that CEF’s are often ignored by larger and institutional investors.
Compensation does not match their needs
Some advisors are compensated from the mutual fund companies recommend to their clients (12b-1 fees). Because CEF’s do not issue new shares there is no reason to pay advisors to solicit them. This makes closed-end funds unattractive for any fee-based or commission compensated advisors.
Blue Bell Private Wealth Management is an independent fee-only advisor which allows us to act in our client’s best interest 100% of the time. We believe that when properly researched and purchased a closed-end fund can be a better alternative to an open-ended mutual fund.
We provide complimentary portfolio reviews to anyone. Together we can sit down and see if your investments are in line with your goals. Check out our availability here or give us a call at 610-825-3540.
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