By Richard F. Gibbons
When seeking diversification, opportunity and value, savvy investors often turn to one of the least-explored areas of the stock market—closed-end funds. Closed-end funds are professionally managed investment companies that invest in stocks and/or bonds. They issue stock which is brought public in an initial public offering (IPO). The net proceeds raised from the IPO are invested by the fund manager in the types of securities laid out in the prospectus.
Three Types of Closed-End Funds
There are three general classifications of closed-end funds:
• Bond Funds. In general, closed-end bond funds invest in debt instruments to provide current income and stability of principal. Each has a different objective which dictates the fund’s composition, its average maturity and the grade and type of investments. Relatively high dividend yields are the main attraction of closed-end bond funds. Of course, the composition of each fund will determine the current yield and overall safety of the investment. Some funds invest strictly in U.S. government securities, resulting in lower relative yields but greater safety.
• Equity Funds. Closed-end equity funds invest in various combinations of stock investments to provide either income or capital appreciation, or both.
• lnternational Equity Funds. Closed-end international equity funds may be one of the easiest ways to participate in foreign markets. Single-country funds invest in the stocks of an individual country. Regional funds invest in companies located in a particular region of the globe, such as Asia, Europe or Latin America. Emerging markets funds invest solely in companies located in emerging markets, such as the Pacific Rim.
International equity funds may not be suitable for all investors, partly because they involve political and currency exchange risk. Fluctuations in the value of the dollar relative to other currencies will affect investment results. In general, the weaker the performance of the U.S. dollar versus the foreign currency, the better the net investment results for U.S. investors and vice-versa.
Closed-End Funds Sell at Discounts or Premiums to NAV
Net asset value, or NAV, is the market value of a closed-end fund’s assets (less any liabilities per outstanding common share). Closed-end fund NAVs are published weekly in major financial publications. You buy and sell shares of a closed-end fund in the same manner as any stock. Most closed-end funds trade on the New York Stock Exchange. The share price is a function of supply and demand. By contrast, open-end mutual funds are required by law to issue and redeem shares directly with investors and always at the prevailing NAV, or the per share value of the securities owned. Since closed-end funds issue a fixed number of shares at one time, which thereafter trade freely on the market among investors, depending on investor demand, a fund’s share price may fall below or rise above its NAV.
When a fund’s share price is higher than its NAV, it is said to be selling at a premium, and when the share price is below NAV, it is said to be selling at a discount. It is typical for closed-end fund share prices to be driven to premiums during times of euphoria in the financial markets and to discounts during uncertain times.
The Benefit of Buying Discounts
As consumers, we are attracted by lower prices, and a quality closed-end fund selling at a discount to NAV may, in effect, offer an attractive investment opportunity. Investors stand to benefit in three ways when they buy a fund at a discount to NAV.
• If interest rates rise, bond prices and the fund’s NAV decline. The discount might protect the share price from declining as much.
• If interest rates decline, bond prices and the fund’s NAV increase. The share price should also rise, perhaps by more than a comparable fund selling at a premium.
• The discount itself might narrow; that is, the share price might approach the NAV. In essence, this occurs when the share price of the fund outperforms the investments held by the fund, and would take place as financial markets advance. Discounts have also narrowed when fund managers repurchase shares after the stock price has fallen significantly below NAV.
However attractive a discount might be, bargain hunters should keep in mind that NAVs are “moving targets.” The fundamentals are just as important as the discounts. Indeed, there is always the risk that the underlying assets in the fund will decline in value. Thus, it is recommended that investors always seek funds with investment policies and characteristics that match their investment objectives.
Other Benefits of Closed-End Fund Investing
In addition to the opportunity to buy assets at a discount to their market value, closed-end funds feature these benefits:
• Professional management. An investor can select funds run by major fund managers who have broad experience and impressive track records.
• Diversification. Most investment professionals recognize the importance of diversifying both within a particular asset class or market and among different markets. Through closed-end funds, an investor can easily, conveniently and economically build a diversified portfolio. This can be particularly relevant to international investing. A single closed-end international equity fund can provide diversified participation in a single country or a geographic region.
• Access to specialized markets. Closed-end funds allow investors to participate in specialized markets that are difficult or prohibitively expensive to access. This is a meaningful advantage when participating in many foreign markets.
• Liquidity. If the situation dictates, closed-end funds can be readily sold, since they are exchange-traded at the current market price, which may be more or less than the original investment price.
Richard F. Gibbons is an account executive with Dean Witter Reynolds Inc., in Boston, MA.