Taking advantage of a deal is something that everybody wants to do. It is why individuals wake up at four in the morning on Black Friday to fight crowds and stand in line for hours. It is also the reason shoppers spend the time to clip coupons.
In essence, shoppers are willing to seek these bargains because for every dollar they save, they have an extra dollar to spend on something else or to use at a later date.
In the investment world, many closed-end funds offer this exact type of value proposition to investors. Often times, closed-end funds trade at a discount. This means that investors can buy a dollar’s worth of assets for substantially less than what they are actually worth. Today, many closed-end funds are attractive because of widening discounts.
To assess whether closed-end funds may be the value you are looking for in your portfolio, let’s first take a look at the basics of what they are.
A closed-end fund is an exchange traded security that issues a fixed number of shares to investors through an initial public offering. The proceeds raised from the IPO are then invested in line with the strategy of the fund. At the end of every trading day, the value of the closed-end fund is calculated and divided by the number of shares outstanding to determine the value of each share; this is the fund’s net asset value (NAV).
Because only a fixed number of shares are issued, shares of a closed end fund can trade above or below the NAV due to the supply and demand of the market. If the shares trade above the NAV, a fund is trading at a premium. Conversely, if the shares trade below the fund’s NAV, the fund is trading at a discount. Due to the volatile nature of the stock market, closed-end funds can trade at varying levels of premiums or discounts.
Currently, closed-end funds are beginning to widen out significantly and trade at a discount. In the past year alone, from August 2012 to August 2013, the number of closed- end funds trading at a double-digit discount have almost tripled from 12 percent to 34 percent. This means that roughly a third of closed-end funds can be purchased for less than ninety cents on the dollar.
Yet this does not mean anyone can buy closed-end funds and expect big returns. It takes insight and experience to discern when to purchase closed-end funds. For example, at the end of August 2012, 49 percent of the closed-end funds were at a premium. This means that an individual would have paid more than the collective value of the fund’s assets.
In comparison, as of August 2013, only 10 percent of closed-end funds were at a premium. Because of the discount widening, many investors who purchased their shares at a premium have either seen a reduction in gains or even taken losses.
When an investor is able to purchase a closed-end fund at a discount the returns they receive come from two sources. The first source is the performance of the underlying securities that the fund is invested in. For example, assume an investor bought a closed-end fund that invested in the S&P 500 index at a 7 percent discount. If the S&P 500 was up 10 percent, you would expect the closed-end fund to also be up 10 percent.
However, this is not the case because the discount was not factored in. To continue with our example, let’s assume the discount also narrowed to 2 percent. If this happened, your investment return would be +15 percent. The first 10 percent came from the performance of the securities, but the other 5 percent is the second source of return, which is discount narrowing.
If an investor had just purchased a S&P 500 mutual fund they would have received a return of 10 percent. However, if the investor had purchased a closed-end fund instead, they would have received an extra 5 percent by buying the closed-end fund at a discount and waiting until the discount narrowed to sell.
As with any investment, buying closed-end funds is rarely this simple. For investors to take advantage of and navigate closed-end funds, it requires daily monitoring, knowledge of the funds, and staying up to date on the closed-end fund industry. While this may be difficult for individual investors to do on their own, they can utilize the service of an active investment manager who has in-depth knowledge, experience and a proven track record to invest on their behalf. Overall, the outlook for closed-end funds is very bright and it appears there are plenty of opportunities to come.
Byron S. Sass is a fixed income analyst/account manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.