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Closed-End Funds: Buy at Discounts and Sell at Premiums

By Jim Fink on May 14, 2012

While we all like to analyze individual stocks and invest in those we think can beat the market, it is sometimes wise (and certainly less time-consuming) to hedge your bets and achieve instant diversification through a mutual fund. Closed-end funds (CEFs) are actively managed mutual funds that trade on stock exchanges.

They’re called “closed” because they don’t accept new investment dollars or redeem existing investment dollars – the investment capital is fixed at the time of the initial public offering (IPO). The only way to invest in CEFs after their IPO is by purchasing shares on a stock exchange.

Exception: CEFs may periodically conduct “rights offerings” that permit current stockholders to purchase additional fund shares directly from the fund.

CEFs don’t permit investors to cash out at the fund’s net asset value (NAV) — the per share value of the fund if you were to add up the dollar values of all the individual securities in its portfolio and divide by the number of shares outstanding. Instead, shareholders must sell their shares to other investors on an exchange. Thus, share prices are subject to the psychological whims of investors, and shares often trade at wild deviations from the fund’s NAV.

Only Invest in CEFs Trading at a Discount

If you wait until a CEF trades below its NAV, you are setting yourself up for a double benefit. Not only can you gain from the capital appreciation of the securities held by the CEF, but you also can profit if the price of the CEF itself moves up toward its NAV. Of course, nothing says that the discount at which a CEF trades can’t widen even further, so you should look at the discount’s 52-week average to make sure the discount hasn’t historically been much greater. A good place to check out a CEF’s 52-week average discount is www.cefconnect.com.

The key to successfully investing in CEFs is to buy them when they are selling at a discount to NAV. Of course, as with stocks, it’s important to investigate why they’re “on sale” — and find out if you’re really getting a bargain. Some CEFs trade at a discount because investors lack confidence in the management team, there is a large unrealized tax liability, or the fund employs high-risk leverage, so it is important to do your due diligence, just as you would with any investment. In other words, a CEF trading at a discount to NAV does not automatically mean that it is a bargain.

Stay Away from CEFs Trading at Premium

In contrast, a CEF trading at a premium to NAV is almost never a good investment. Premiums exist due to investor speculation or confidence in the investment prowess of the manager. For example, bond funds managed by PIMCO often trade at a premium because investors respect PIMCO’s bond trading prowess. I once shorted a PIMCO CEF trading at a double-digit premium only to find it expand to an even greater premium. I didn’t enjoy that experience, so I am hesitant to short CEFs trading at a premium (especially any managed by PIMCO), but I still won’t buy them either.

Investing Daily’s Ben Shepherd is not a fan of CEFs for a couple of reasons:

Closed-end funds are burdened with two significant disadvantages.

The most obvious problem is pricing. Regardless of the quality of the bonds making up a closed-end fund, because shares trade just like any other stock, they often change hands at substantial premiums or discounts to their net asset value (NAV). Unless you’re engaging in a bit of arbitrage or making a speculative bet on the recovery of specific areas of the bond market, that’s a disadvantage to investors.

There’s also the issue of leverage. Closed-end funds have a long history of issuing preferred shares and auction rate securities (ARS) in order to juice the returns they offer investors. That can be attractive in bull markets, with positive returns amplified by the leverage. But in down markets plunging share prices are just as exaggerated. And closed-end funds aren’t always as transparent on this issue as they should be.

Focus on CEFs with Low Expense Ratios

Another important factor to consider is the CEF’s expense ratio, which includes management and marketing fees. Fund performance is uncertain, but fund expenses are predetermined, so investing only in CEFs with modest fees is a smart way to reduce your risk. Theoretically, CEFs should have lower expenses than open-ended funds because CEF managers have a captive investment base and don’t have to worry about redemptions — which can add to trading costs. In reality, I have found many CEFs charge exorbitant fees either because their fund’s asset size is too small – thus forcing a higher percentage of fixed costs to be absorbed per investment dollar — or because they unethically take advantage of the captive investment base, knowing that redemptions are impossible.

Buying CEFs at Their IPO is a No No

Never buy a CEF at the time of its initial public offering (IPO). Brokers often tout CEF IPOs as “commission-free,” but what they don’t say is that the offering price includes an embedded sales charge, resulting in a price that is around 5% higher than the fund’s NAV. For example, many CEF IPOs are offered at a price of $20 with an initial NAV of between $19.00 and $19.10. Buying $19 worth of assets for $20 is not a smart way to invest, especially since academic studies have shown that the typical CEF loses 8% of its value in its first 100 days of trading and 12.6% in the first five months.

A 2004 study by Thomas J. Herzfeld Advisors drew this conclusion about CEF IPOs:

Investors in IPOs of closed-end funds rarely make money just after the offering: In fact almost all investors wind up underwater over the short term. But there is often a lot of money to be made by buying the new issues three to six months after launch for two reasons: There is usually a lack of research on these issues and many are dumped for tax losses toward the end of the calendar year.

List of CEFs Worth Considering

Below is a list of CEFs that pay at least a 5% annual dividend, are trading at a discount to NAV of at least 8%, and charge no more than 1.25% of assets in non-leveraged management expenses. They are not recommendations, but merely a starting point for further research.

Fund

Annual Dividend Yield***

Deviation From NAV*

52-Week Average NAV Discount

Expense Ratio**

Annualized Total Return Last 10 Years

Type of Fund

BlackRock Resources & Commodities Strategy (NYSE: BCX) 10.29% -8.72% -6.80% 0.84%  -22.99% (since Mar. 2011) U.S. Equity – Commodities

China Fund (NYSE: CHN)

14.05%

-9.74%

-9.94%

1.11%

17.66%

Emerging Market Equity

Adams Express (NYSE: ADX)

6.07%

-13.35%

-14.65%

0.54%

4.24%

U.S. Equity

John Hancock Tax-Advantaged Dividend (NYSE: HTD)

6.69%

-8.30%

-7.27%

1.24%

7.68% (since Feb. 2004)

U.S. Equity

Royce Value Trust (NYSE: RVT)

5.80%

-12.31%

-13.42%

0.99%

4.61%

U.S. Equity

Source: www.cefconnect.com

*As of May 11, 2012. **As of Dec. 31, 2011. ***May include capital gains or return of capital.


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  1. Jim Fink
    Jim Fink Reply October 11, 2012 at 1:37 AM EST

    Hi Vegard,

    Closed-end funds can be sold short just like any common stock:

    http://irving.vassar.edu/VCEWP/VCEWP63.pdf

    Best,

    Jim

  2. avatar
    Vegard Reply October 11, 2012 at 1:23 AM EST

    You’re saying you once shorted a CEF trading at a premium. I’ve heard it is not possible to short CEFs, don’t know why though. It would make sense that you could short shares of a CEF the same way as common stocks, or how does this really work? With PIMCO funds trading at a 70% premium these days it seems like a decent opportunity, although it would be expensive to short something with a 10% yield…

  3. avatar
    Perry Adams Reply May 19, 2012 at 12:57 PM EST

    How long have they sold at a discount? Is there any hope of them getting back to a par or above par? Do any of them pay a good dividend? otherwise it’s like buying stock in a horse buggy company.
    I would be better to come up with a list of closed end funds that sell at a 5% to 10% discount but pay a high dividend without dipping into capital or paying a dividend as a return of capital.

  4. avatar
    Mike Bouchard Reply May 18, 2012 at 2:25 PM EST

    Why do the Net Asset Values on some of these funds change daily ? I thought NAV is calculated by taking total net Assets less Total liabilites and then divide by the number of oustanding shares. I know over time assets and libialities values will change but hardly should they change daily. It is as if the NAV price is fluctuating with the market price instead of being valued by the balance sheet.

    • Jim Fink
      Jim Fink Reply May 18, 2012 at 3:29 PM EST

      Hi Mike,

      CEFs are passive investment companies, not operating companies, so their only assets are marketable securities. Consequently, when their holdings of securities change price, their NAVs change price.

      Best,

      Jim

  5. avatar
    don jowers Reply May 14, 2012 at 6:05 PM EST

    BCX pays it’s distributions in ROC. Is this a negative? Do you like the Blackrock fund family. Thank you.

    • Jim Fink
      Jim Fink Reply May 14, 2012 at 10:57 PM EST

      Hi Don,

      BCX has only been around about a year, so it’s too early to tell whether having 90% of annual distributions being ROC is a negative or not. The CEF is trading a double-digit discount to NAV so a return of capital allows you to cash out a portion of your investment at NAV which is nice. Furthermore, the fund owns some MLPs which pay out distributions in the form of ROC. MLPs have performed marvelously while making ROC distributions.

      BlackRock has a lot of funds that perform well.

      Best,

      Jim