HOW TO SELECT A CLOSED END MUTUAL FUND
In a previous article named “The ABCs of Closed End Mutual Funds” I discussed the basic differences between closed end funds and ordinary open end funds including the key concept that closed end funds can often be traded at market prices that are discounted from the fund’s NAV (net asset value per share).
For example, consider the closed end fund Tri-Continental Corporation that trades on the NYSE under the ticker symbol TY. This fund recently had about 58 million shares outstanding and a portfolio of large-cap US stocks worth about $1.4 billion (on a net basis). Given these values, the NAV of the fund on a per share basis is found by dividing the $1.4 billion net asset value by the 58 million shares to get a per share NAV of around $24 per share. But the market price of TY typically trades at a substantial discount to its NAV. For example, if the discount on TY’s $24 NAV is 15%, then the market price of TY would be about $20.40. The value is found by subtracting 15% of the NAV ($24) from its NAV (i.e., multiplying the NAV by 0.85).
In this example, TY’s 15% discount indicates that an investor can purchase $24 of portfolio value per share inside the fund by investing only $20.40. So why do closed end funds often trade at values other than their NAV?
The answers must come from any added benefits or costs caused by the fund standing between each investor and their money, and by the management of the fund having control over the fund’s assets.
There are several potential reasons to think that it is good to have the fund and its managers handling the money: (1) perhaps the managers have superior investment skills, (2) perhaps the managers can invest in assets such as loan participations or foreign securities that investors cannot easily access on their own, and (3) perhaps the managers can obtain financial leverage on better terms than the investor can.
There are two major reasons to think that it might be bad to invest in a closed end fund: (1) the fund might have higher expenses than the investor can find elsewhere, and (2) the managers might not be truly serving the best interests of the fund’s investors due to conflicts of interest, incompetence or laziness.
Talented investors or investment advisors with patience, effort and skill can identify when closed end funds are trading at such attractive discounts that they can serve valuable roles in the asset allocation process. For example, in 2015 many closed end municipal bond funds often traded at discounts greater than 10%. Those funds offering low cost leverage, modest expense ratios and generous distribution rates were potentially more valuable additions to the portfolios of many investors than most open end funds. In 2008 at the depth of the financial panic some funds traded at discounts of well over 20%. Periodically sectors become unpopular and closed end funds investing in that sector may experience price drops that make their discounts fall to very attractive levels.
Successful investing in closed end funds requires an ability to evaluate the benefits and costs of using closed end funds versus using low-cost alternatives such as open end mutual funds and exchange traded mutual funds with low expense ratios. Whether purchased as long term “buy and hold” investments or as speculation in hopes that the discount will narrow, closed end funds periodically trade at discounts that offer exceptional investment opportunities to talented, experienced and patient investors.