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Closed-End Funds Quietly Offer Surprising Advantages

Mark Ingebretsen

If people understood what closed-end funds were all about, they'd like them a lot more. At least that's the message you get when you explore the Web site for the Closed-End Fund Association (CEFA). The nonprofit trade group's site is one of just two spots on the Web devoted solely to closed-end funds. The other is the Internet Closed-End Fund Investor, a kind of online newsletter.

Spend a little time at either site and you may start thinking that closed-end funds deserve a look -- especially when markets turn volatile.

What Are They?

At first glance, closed-end funds resemble mutual funds. Their managers actively invest the funds' assets in growth stocks, bonds, entire sectors, emerging markets, whatever. Unlike mutual funds, closed-end funds raise their investment capital at the time they launch. That pool of capital hopefully grows within the fund throughout its life. And the whole while, shares of closed-end funds trade just like stocks.

The Downside

Dagen McDowell's recent TSC column on closed-end funds provides a lot more background, including some of the reasons why closed-end funds are often maligned. Chief among those reasons is the fact that closed-end funds usually trade at a discount to their net asset value. At first that sounds great. After all, you're buying assets at a bargain price. But here's the downside: Sometimes the spread between net asset value and the fund's share price can actually widen as stocks decline. Investors, then, get hit with a double whammy.

And in fact, investors have mounted lawsuits against funds like Scudder Kemper Investments New Europe fund and Alliance's Spain SNF fund, claiming the funds' managers failed to address the persistent gaps between net asset value and share price. That, of course, has helped give closed-end funds a bad name.

The Upside

But a quick read of the independent research reports at the Closed-End Fund Association site may convince you that closed-end funds have their upside, too. For one thing, many closed-end funds distribute capital gains and dividends based on net asset value, which means the discount you paid for the fund actually gives you a degree of leverage. Closed-end funds can also be traded throughout market hours. So if there's a slide, such as the one that occurred last week, you're able to get out fast. By contrast, many online brokers only trade mutual funds at the end of the day -- in effect, holding your money prisoner.

And the biggest advantage closed-end funds have over traditional mutual funds: Because they control a fixed amount of capital, closed-end funds don't have to dump stocks at fire-sale prices to meet redemptions. Again, that's a nice advantage when the markets turn sour. Also, since closed-end fund managers needn't worry about redemptions, they don't have to maintain sizable cash reserves. So, theoretically, more of your investment gets put to work.

Only 530 closed-end funds trade on U.S. exchanges, according to "All About Closed-End Funds," a recent report by Paine Webber. Their assets as of February totaled just $107 billion -- a drop in the bucket compared with the trillions investors have poured into thousands of traditional mutual funds.

Screening Your Options

The CEFA Web site has a screening tool that lets you cull through this list to find the kind of closed-end fund you're looking for to balance out your portfolio or satisfy some other objective.

If you wanted to buy a Turkish or Chilean fund, for example, your choices would probably be limited to closed-end funds. Again, because the funds' managers needn't worry about redemptions, they're free to buy and hold those countries' often illiquid stocks.

If you're a fund switcher -- that is, someone who moves in and out of funds in days or weeks the way a position trader moves in and out of stocks -- then check out some of the more volatile closed-end funds using the CEFA screening tool. As with stocks, you can use limit orders when trading closed-end funds. And you can look for fills within the bid/ask spread, the way daytraders do. Some closed-end funds offer a pretty wild ride, both long-term and intraday. Imagine if you'd bought the sparsely traded closed-end fund Engex EGX last November when it was hovering around $13. Shares in the fund, which invests in emerging companies and turnarounds, peaked at around $50 during January to March, before dive-bombing in April. On Thursday, it ended the day at 20, up 2.

Promising Value Plays?

Other funds, such as the RENNRenaissance Growth & Income III, have managed to hang on to most of their year-to-date gains. Shares rose from about $9 to $15 from January to March. Thursday the fund closed at 13 3/4, up 3/4.

Despite that respectable performance, Renaissance Growth still trades at roughly a 20% discount to its net asset value. In fact, 89% of closed-end funds trade at a discount, according to the Paine Webber report. The reasons remain somewhat mysterious. The report speculates that investors factor in a fund's holdings in illiquid securities. Others believe that closed-end funds trade at a discount because few people pay them much attention. And it's easy to understand why. Once a closed-end fund is up and running, there's no need to advertise it further. So most simply plod along in obscurity, like the MGCMorgan Greenfield Small Cap fund, which had a total return of 45% last year but still traded at a 12% discount, as of last week. That discount doesn't reflect any potential bargain prices among the stocks the fund holds, after those stocks took their hits last week.

Does that sound like a promising value play?