Shopping for investments usually isn't like shopping for clothes — just because the price has dropped doesn't necessarily mean it's a good deal. But you can tell when a closed-end mutual funds might be a bargain.
Bullish investors like to spin the current market problems as saying that the downturn has put great names “on sale.”
In a typical retail sale, however, consumers know just what they are getting, because they can see that the sale takes, say, 25 percent off the ticket price. With investments, however, the typical investor is guessing at how big a bargain they’re getting.
The one exception is closed-end funds, where investors looking for both bargains and income streams get a price tag that shows the size of their current discount. With that in mind, closed-end funds are an intriguing choice for current market conditions.
“When people see that they actually calculate the discount on a closed-end fund, I think they believe this must be the scratch-and-dent sale on portfolios, that something has to be wrong,” said Jeff Tjornehoj, senior research analyst at Lipper.
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“Nothing could be further from the truth. Many closed-end funds resemble the funds you might hold in your 401(k), but you know exactly how much of a discount you are getting, so that you can take advantage of other people’s panic.”
Closed-end funds are an esoteric, misunderstood investment. Few people wake up thinking “I need to diversify into closed-end funds today,” so the funds are sold on the basis of a broker’s sales pitch.
At their best, closed-end funds can be a highly effective investment tool. At their worst, they can be highly leveraged, volatile bad deals.
Unlike a traditional or open-end mutual fund — which typically issues new shares whenever buyers pony up cash — closed-end funds issue a limited number of shares, which trade like a stock, bought or sold minute-by-minute with a price driven by market sentiment.
A traditional fund’s price is always set at day’s end, and equals the net asset value of the underlying holdings. A closed-end fund can trade at a premium or a discount to the net asset value of the holdings. The market’s recent miseries have made discounts grow.
In most conditions, the typical closed-end fund trades at anywhere from 2 to 10 percent less than its net asset value; today, double-digit discounts are common.
Here’s how that plays out. Say you want a dividend-oriented fund that delivers an income stream, because capturing dividends is a big reason why stock investors stay the course during recessions. Many closed-end funds specialize in dividend strategies, such as the BlackRock Dividend Achievers Trust (BDV).
You’re looking at a large-cap value portfolio filled with brand-name stocks, currently trading at a discount of more than 13 percent to net asset value. That means you are paying about $9.80 to buy about $11.30 worth of stock; even better, you’re getting a current yield of 7.5 percent in the process.
“Because you can see the size of the discount, you get to see how big of a sale there is right now, and that makes the buying case pretty clear,” said Jerry Paul, of Quixote Capital Management in Englewood, Colo. “But investors also need to understand the issues that can be involved in closed-end funds. It’s not as easy as ‘Find a good yield and a big discount and that’s it.’ “
The issues you’ll want to investigate include leverage — because many closed-end funds use riskier strategies to achieve their ends, and the tightening credit market could smack down issues that borrow heavily — the assets the fund holds, and what is driving the discounted price.
You’d like to understand why the market is so unimpressed that it has let the share price drop below net asset value; it may be that the market has soured on the type of assets the fund holds, but it could be fears about leverage and more.
Chuck Jaffe is a senior columnist at MarketWatch columnist. He can be reached at firstname.lastname@example.org or Box 70, Cohasset, MA 02025-0070.