Closed-End Funds Dive in Down Markets

A byproduct of the financial crisis, as has been the case in past crises, is that closed-end funds come unglued. This has happened before, is happening now and, more importantly, will happen again.

The reason for this is the structure of the product. They have a fixed number of shares (save for the occasional secondary offering) and so the market price can deviate from the net asset value of the fund. This creates a discount or premium to the net asset value.

The strategy of buying a closed-end fund that has a wider discount than normal and selling it when the discount narrows or even swings to a premium is somewhat popular and valid, although it is not easy.

Then there are times, like now, where things move violently out of sorts. Below are charts of the discount history of three not-so-randomly chosen closed-end funds. They all show a similar cliff dive very recently. They are not so randomly chosen, because earlier this week, Jeff Saut recommended them to clients at Raymond James.

The funds are BlackRock Strategic Dividend ( BDT), BlackRock Enhanced Dividend Achievers ( BDJ) and Eaton Vance Tax-Advantaged Global Dividend Income ( ETG). According to Saut, all three have blue-chip portfolios and they pay generous dividends.

Many closed-end funds have blue-chip portfolios and pay generous dividends. The point is not to pick on Saut or the funds he chose but instead to create a better understanding of how the product works. During times of unusual uncertainty or panic, it makes sense to expect closed-end funds to react very negatively.

A big reason for this is that they are an easy source of funds when the market is going down, and the psychology of fear in a downturn often causes an over-reaction on the part of the market. As a result, the market prices lose value faster than the NAV.

In the last couple of months, I have had quite a few emails and comments on my blog asking why some funds are down a lot more than others. In all of these questions, there was a lack of differentiation between closed-end funds and exchange-traded funds. ETFs don't have an issue with prolonged deviations between market price and net asset value.

When demand for an ETF increases, more shares are created, and when demand decreases, shares can be taken back in. In addition to the mechanics of ETFs, there are traders that arbitrage away small discounts and premiums when they occur.

None of this pertains to closed-end funds.

This does not make closed-end funds a bad product. When the markets start to recover and act normally, it is a good bet that the discount on many funds will return to normal levels, which means at some point, CEFs become a good trade for more aggressive investors. The risk in going with Saut's picks now is not the management of the funds but whether the crisis is over.

Equity markets are down 32% so far this year and just about every fixed-income market is under some form of distress. From here, an additional 20% drop is unlikely, but if that is what happens, I would expect the market price of many closed-end equity funds to do worse.

Having the correct expectations is crucial to not making panicked decisions.

At the time of publication, Nusbaum had no positions in the securities mentioned, although positions may change at any time.

Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

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