Pick a stock. Any stock. And invariably, one investor will argue it's cheap while another will say it's expensive. Who's right? There's really no way to answer that question… until it's too late. But the same can't be said about closed-end funds. A first grader with a good grasp of addition and subtraction can tell whether one is cheap or expensive.
Since closed-end funds issue a fixed number of shares, supply and demand determines market prices. That means it's possible for such funds to trade at a price that's greater than (a premium) or less than (a discount) the actual value of the securities in the portfolio (net asset value or "NAV").
And currently, the average closed-end fund is cheap. It's selling at about an 8.5% discount, more than double the historical average, based on the Herzfeld Closed-End Average Index.
What does that mean? Well, if the fund's manager sold all of the fund's holdings, investors would earn an instant 8.5% profit. Not bad. But during intense market selloffs, it's not uncommon for closed-end funds to trade at much bigger discounts. That's precisely what happened at the end of 2012. When Congress couldn't come to any sort of an agreement over the "Fiscal Cliff," the average discounts hit double digits.
Why? As we all know, when investors get scared, they sell indiscriminately. Companies with stellar earnings growth and fundamentals get tossed just as quickly as companies with terrible fundamentals. Yet very few investors understand the dynamics of closed-end funds, so they sell out of them much more aggressively.
Case in point, during the 2008 stock market swoon, almost 200 closed-end funds traded at more than a 20% discount. And a couple dozen closed-end funds traded at discounts of up to 30% to 40%.
When such steep double-digit discounts to NAV materialize, we should be buyers, not sellers.
Closed-End Bargains Don't Last Forever
Huge disparities between market price and NAV don't last forever. Savvy investors recognize the bargains and eventually swoop in to capitalize on them. That appears to be happening now. And you should look to be one of them.
Practically speaking, I recommend monitoring the average premium/discount to NAV on a weekly basis. Barron's makes it easy. Each week it publishes the Herzfeld Closed-End Average Index, which tracks the average premium/discount for 15 large closed-end funds.
I also recommend focusing on closed-end income funds, ones that invest in bonds. And here are the two reasons why…
First, they offer more downside protection because we're investing in bonds. Remember, unlike stocks, fixed-income investments have a predetermined value at maturity. So despite any wild market swings, if we hold on long enough, bond valuations will recover as maturity draws near.
Second, closed-end income funds pay us to own them via dividends while we wait for the temporary discounts to NAV to disappear. Many even pay monthly dividends.
That's why the last time closed-end income funds sold off so sharply, I recommended that readers pick up shares of the Eaton Vance Senior Floating Rate Trust (NYSE:EFR). Sure enough, they were sitting on a healthy double-digit profit in no time.
For investors who value solid income with the potential for double-digit appreciation, too, I'm convinced no better opportunity exists than buying closed-end income funds during market selloffs.
In fact, a recent screen turned up the following 10 income-oriented funds that are trading at - or close to - double-digit discounts to NAV.
- Ellsworth Fund (NYSEMKT:ECF)
- Bancroft Fund (NYSEMKT:BCV)
- American Strategic Income II (NYSE:BSP)
- Nuveen Diversified Currency Opportunities (JGT)
- Oxford Lane Capital Corp (NASDAQ:OXLC)
- Western/Claymore Inflation-Linked Securities & Income Fund (NYSE:WIA)
- NexPoint Credit Strategies Fund (NYSE:NHF)
- Advent Claymore Convertible Securities and Income (NYSE:AGC)
- Federated Enhanced Treasury (NYSE:FTT)
- American Select Portfolio (NYSE:SLA)
Please note, I'm not recommending any of the funds listed above. Instead, I'm sharing them to prove the point that opportunities exist in the current market. Accordingly, the list should only serve as a starting point for further research.
Bottom line: Closed-end income funds are a great buy during market selloffs. I recommend you have a short-list of funds you'd like to own when the average discount to NAV hits double digits.