Hang on and ride it out is sometimes the best (and often only) plan to deal with market volatility. With few options left to combat recent gyrations, one asset class is gaining traction with retail investors—closed-end funds.
“Open-end mutual funds continuously offer their shares to investors and stand ready to redeem their shares at all times,” according to the Closed-End Fund Association (CEFA), a national trade organization representing the industry. “Transactions in shares of mutual funds are based on their net asset value (NAV), determined at the close of each business day.”
Closed-end funds, conversely, have a fixed number of shares outstanding and are traded on an exchange between investors. CEFA notes transactions in shares of closed-end funds are based on their market price as determined "by the forces of supply and demand among investors in the marketplace." This market price may differ from the fund’s listed NAV, something that makes then attractive in times of volatility.
“When fear increases, investors obviously look to exit the market,” says Patrick Galley (left), chief investment officer with RiverNorth Capital, a money management firm in Chicago that specializes in closed-end fund investments. “At that point, sellers outpace buyers. This puts downward pressure on the underlying price. Open-end funds have to buy back the shares, so that downward pressure isn't as significant. With closed-end funds, it is much more so and results in shares trading at a discount."
Galley says the recent controversy over national debt negotiations put this downward pressure on closed-end shares, which “pushed out” the discount between the NAV and the actual price negotiated between buyers and sellers by 7% over the course of just a few weeks.
“It was a good time to buy closed-end funds,” he says, noting his firm “bought into that fear.”
But Galley warns such periods can “whipsaw” back and, as always, investors need to be aware of the risks involved.
“People will make the argument that closed-end funds can be more volatile that the overall market because they can snap back rather quickly,” he says. “We counter that it’s good to take advantage of that volatility, but you never want to have your entire portfolio in closed-end funds. However, you always need ‘dry powder,’ and if you have ETFs, open-end funds and cash, you may want to think about selling some and buying closed end funds.”