Closed-End Funds: Structure and Price Discount Are Key to Potential Returns

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 |  Includes: GCE, PCEF
by: John Tobey, CFA

Yesterday, I listed four closed-end funds that invest in China. Such funds are well suited to specialized investing, like developing/emerging markets. In addition, there are market environments when closed-end funds in general offer price advantages. I believe now is one of those times.

If closed-end funds are new to you, there are good materials at the Closed-End Fund Association website (http://www.closed-endfunds.com/). Two free booklets are particularly helpful: Closed-End Funds 101 and Understanding the Advantages of Closed-End Funds. The site also contains information on each of the closed-end funds.

A quick background note on my closed-end fund experience: From 1986 to 1994, I was SVP, then President, of Liberty Asset Management, the fund manager for the Liberty All-Star closed-end funds. This included an offshore global equity fund with foreign managers. Through 1997, I published a newsletter, Closed-End Fund Investor, and was instrumental in creating the Closed-End Fund Association (CEFA). I currently have no affiliation with the Liberty All-Star Funds or CEFA.

There are two particular closed-end fund benefits that are important to us:

First, the structure allows the fund manager to focus on what matters most: the fund’s investments. Because closed-end funds are not subjected to investor flows, the fund manager is able to optimize the fund’s holdings, creating exactly the portfolio desired with minimal cash reserves. This advantage is especially important when the holdings are volatile or have limited trading – like in developing markets.

In a typical mutual fund (aka, an open-end fund), the fund manager must hold enough cash to meet possible redemptions, yet be prepared to add to holdings if new money is received.

This cash flow effect is a real challenge in optimistic and pessimistic times. Investors, as a whole, tend to be net sellers at market bottoms and net buyers at market tops. It means that, in pessimistic times, the open-end fund manager has to dump cheap holdings to meet withdrawals, saddling the long-term investors with the performance effect and tax consequences. Conversely, in optimistic times, as the money pours in, the fund manager keeps finding cash to be too high and so having to buy at ever-increasing prices – both effects watering down performance for the long-term investors. (This is why so many stock mutual funds closed to new investors in the last bull market.)

Closed-end fund managers, meanwhile, are protected. They get to concentrate on the portfolio they have and not on uncontrollable cash flows.

Second, investor activity does affect closed-end funds, but externally, to the price – and this can mean discounts. A closed-end fund’s price can (and usually does) differ from the fund’s NAV (net asset value). Pessimistic times see the price fall below the NAV, creating a discount. Then, in optimistic times when investors are net buyers of the fund, the price rises relative to the NAV. In some situations, it can even exceed NAV, creating a premium.

Currently, reflecting investors’ feelings, there are widespread, significant discounts among closed-end stock funds.

So, it’s a good time to consider buying closed-end stock funds. When happy times return and stocks are up, the well-managed funds will have performed nicely (as measured by NAV), and the price discount will likely have narrowed, giving investors a bonus gain.

Disclosure: No positions