Fear and greed abound in today’s markets. The sharp decline in U.S. economic growth is spurring worries about a double-dip recession, and many investors are hunkering down. However, there is a bright spot: skittish times mean skittish asset prices, and that’s where the opportunity now lies in closed-end funds.
Closed-end funds, like open-end mutual funds, are registered investment companies. The key difference is that closed-end funds issue a fixed number of shares that trade in the secondary market, just like the shares of any publicly traded company. Similar to stocks, whose share prices are based on supply and demand, shares of closed-end funds can sell at a premium or discount to their net asset value (NAV), or the liquidation value of the securities they hold. Indeed, closed-end funds are among the only publicly traded investments in which we know what they are worth (NAV) and what the market is willing to pay for them (trading price).
Today, there are more than 600 closed-end funds trading on U.S. stock exchanges, and the pipeline is once again growing after falling off in the financial crisis. In 2007, there were 40 initial public offerings (IPOs) for closed-end funds totaling over $27 billion in new assets raised. In 2008 the number fell to just two, totaling $262 million in new assets. Since then, we’ve seen 24 closed-end fund IPOs raising more than $7.6 billion in assets through July 2010.
Closed-end funds are especially appealing in today’s environment because they offer exposure across multiple asset classes through a single fund, plus unique alpha potential. Closed-end funds can invest in domestic stocks, international stocks, investment grade and government bonds and high-yield bonds. The alpha potential is in the inefficiencies of the closed-end market. Closed-end funds are generally owned by retail investors who tend to buy and sell for emotional reasons, such as fear of a recession or over-confidence in a recovery. In addition, many investors will buy income-generating closed-end funds based on yield alone; the crux is that high yields can be an indication of higher risk investments and/or the use of leverage.
As a result, the opportunistic investor with the wherewithal to analyze the closed-end fund space in greater depth can find funds trading at compelling discounts and avoid paying undue premiums. Such an investor focuses on catalysts that can potentially cause a discounted fund’s trading price to rise. These catalysts may include shareholder activists pressuring the board to address the discount, or corporate actions such as a tender offer, liquidation or conversion to open-end funds.
Average discounts were particularly wide during the early summer of this year, but have been steadily narrowing, as measured by the RiverNorth Closed-End Fund Index. As of September 24, 2010 the average discount stands at -1.75%, which is equivalent to buying $1 worth of assets for 98 cents. This narrowing is most likely due to reduced fear of a European sovereign debt crisis and increased demand for yield, which has narrowed discounts, particularly fixed income funds. Although the overall space is narrow, select asset classes such as US equity and real estate are trading at attractive double-digit discount levels. That is in stark contrast to fixed-income funds, such as high yield, which are trading at premiums.
As with any investment, closed-end funds carry risks – discounts can and do widen, after all. I’ll use this column to help decipher the closed-end fund space on an ongoing basis, exploring topics including which market sectors are experiencing widening or narrowing discounts, new IPOs and changes in trading volume. My overall stance: As the bulls and bears duke it out, savvy and informed closed-end fund investors who cut through their noise stand to win out.