Imagine for a moment, you’re a carpenter. You build houses for a living. The tools in your toolkit are everything to your profession. These tools are used to shape, size, and fasten together all the raw materials needed to build a house.
But what if you restricted yourself to only a hand-saw, a hammer, and bunch of nails? (Perhaps you forgot the power-tools at home.) Suddenly, building that house just got a lot harder. Technically you *could* still build a house this way (using hand tools), but it might take a very long time to finish.
Investing is like this too. The tools you use to reach financial independence really matter. If you invest all your money into CD’s, reaching financial independence will seem a long ways off. Stocks will get you there faster, but not without significantly adding risk. Mutual funds add diversification, but at a additional cost. Bonds fall somewhere between CD’s and Stocks on the risk spectrum of potential investing tools.
Every tool has it’s place… even oddball tools that get rarely used. A good investor keeps these tools handy in his or her toolkit, ready to invest when the right situation presents itself.
One such tool that’s almost forgotten these days, is called a closed-end fund.
What Is A Closed-End Fund?
In a few words, a closed-end (CE) fund is a form of professionally managed mutual fund. These funds are considered “actively managed”, and typically are not tied to an index.
Closed-end funds can invest in all the same assets that regular mutual funds might invest in (stocks, bonds, etc.), but this is where the similarities end.
What else is different about closed-end funds?
All closed-end funds have a fixed number of shares. These shares are issued during the fund’s initial public offering, and thereafter the shares will trade on a public stock exchange. Investors buy into the closed-end fund by purchasing shares from other investors (instead of handing money over to a mutual fund company).
This means the amount of capital in a closed-end fund doesn’t grow or shrink when investors join or leave. The fund is “closed”.
This also means that each share in the fund has a real asset value, called the NAV or (net asset value).
Imagine for a moment that a closed-end fund has $100 million in capital, and 10 million shares outstanding. Each share will be worth $10.
NAV = $100 million dollars in assets / 10 million shares
The math to determine the NAV is simple, and closed-end funds regularly publish this value on their website. Whether you actually pay that price is another story.
Share prices are free to fluctuate around NAV.
Why Bother With CE Funds?
At this point you’re probably wondering why anyone would bother with a closed-end fund. After all, we can now find index funds with 0% expense ratios. Zero is pretty hard to beat. In contrast, closed-end funds typically have higher expense ratios ranging from 0.31% to 2%.
With expense ratio’s like that, closed-end funds need a REALLY BIG advantage to be worth it! Thankfully, there just might be one!
Remember when I mentioned the price of closed-end funds can fluctuate independent of the underlying NAV? Sometimes the price of closed-end fund shares will fall significantly below the NAV.
Take for example: Tri-Continental Corp. (Symbol: TY) Tri-Continental is a closed-end fund trading at a 12.5% discount to NAV. The fund primarily holds large cap equities (similar to a S&P 500 fund), and has a 0.66% expense ratio. The details on its holdings can be found here.
Paying lower prices for stocks, ultimately means higher returns — If you’re an income seeker, this closed end fund provides a 3.32% yield. Compare that to the yield of a S&P 500 index fund (1.69% yield). The difference in income is significant if you’re trying to live off investments.
Tri-Continental is merely one example. Doing a quick search I found over a hundred different closed-end funds trading at a discount to NAV.
The discount varies from fund to fund, but I’ve seen discounts as large as 36% of NAV. This can make a dramatic difference in what you’re taking home at the end of the day… and it goes a long ways to making up for those high expense ratios.
The more important question is — Will the discount to NAV be permanent or temporary? The answer is, it depends. Some CE funds will eventually bounce back to their NAV, and others will continuously sit at a discount for years.
When CE Funds Go On-sale
Most of the time, popular funds don’t trade at a discount to NAV for long. In contrast, the stock sectors seeing the largest declines will often trade at large discounts to NAV. This can last until the sector recovers, or until the fund decides to close.
Right now, the Energy sector has lots of closed-end funds trading at large discounts to NAV. Nobody wants to own energy funds right now, so the price of Energy MLP closed-end funds is significantly discounted.
If you’re willing to bet on the recovery of the energy sector this could be a opportunity. A closed-end fund could give you the opportunity to buy assets at a significant discount to already discounted market prices.
Here’s a list (pulled from cefa.com) of Energy MLP CE funds currently trading at a discount to NAV:
As you can see, the discounts are large. Most of these energy MLP’s are trading at a 20% discount to NAV. That’s significant! You can also see the distribution yield from these funds is equally incredible.
Further Reading: If you want to learn more about closed-end funds, I highly recommend taking a look at cefa.com.
A Word of Warning
One of the big differences between a standard mutual fund and closed-end funds, is that closed-end funds can also use leverage. In other words, borrowed money.
In the list of MLP funds I gave earlier, 100% of them utilized leverage. Leverage allows those CE funds to juice overall returns with borrowed money! This can provide a bigger upside in the form of larger returns.
On the negative side, leverage has a real cost, which is included in the expense ratio. (This partially explains why CE fund expense ratios are so high.) Leverage can dramatically destroy asset values and sink the NAV when markets move in the wrong direction.
Investing in levered closed-end funds is NOT for the faint of heart. It’s important to know what you’re doing before you decided to get involved with leveraged funds.
To give you an idea of the damage leverage can do, take a look at the negative one-year returns in the earlier table of MLP funds! Declines of 40%-90% this year alone! Ouch!
While I’m certainly not recommending novice investors run out and buy closed-end funds anytime soon, the closed-end fund remains a very interesting tool to keep handy in your investing toolkit. The discounts to NAV provide intriguing possibilities for investors looking to capture an economic rebound, or those seeking higher income than your standard index fund.
Most of the time a humble index fund is going to get the job done, but it’s important to remember there are other possibilities. Other tools that can provide you with different outcomes.
Investors tend to treat whatever asset class that is most popular a lot like a hammer. They try to hit everything with it. Sometimes it works, but this may or may not be the most effective solution to achieving your investing goals.
It’s important to keep an mind open, and remember there are plenty of tools in the investor’s toolkit we can use.
Good luck investing!
[Image Credit: Flickr]