These days, consumers are always searching for a deal. Should investors do the same? And if so, where should they look?
It's obvious that consumers' behavior has changed in the past 10 years. During the 2008-2009 financial crisis (the "Great Recession"), they dramatically cut back on spending, leaving retailers sitting on mountains of leftover merchandise. To liquidate that excess inventory, stores began offering shipping deals, coupons, sales and an ever-deepening series of discounts. Although the Great Recession has long passed, according to some retail industry analysts, consumers haven't returned to their old habits. They've been conditioned to expect promotions and discounts, and are reluctant to pay full price.
At first glance, it doesn't seem as if this frugal attitude has carried over into the financial markets. Investors appear to have been happily paying top dollar for growth stocks. Equity valuations have been high by historical standards, and much of the stock market's rise over the past few years was led by hot, high-earnings multiple tech giants.
But there's one corner of the market where investors have been looking to snap up bargains: Closed-end funds. Closed-end funds differ from their open-end mutual-fund cousins in a few important ways. For one thing, their unique structure and exchange trading enables investors to buy a fund for its market price, which can be less (or sometimes, more) than what its holdings are worth -- its net asset value, or NAV.
Conversely, investors looking to buy shares of an open-end mutual fund will pay the NAV, which is set at the end of each trading day. (Note: Closed-end funds are bought/sold at market price plus brokerage commissions/transaction fees. Closed-end funds bought during the initial public offering are purchased at original IPO/NAV plus sales charge. Open-end mutual fund shares are purchased at NAV plus sales charge.) The NAV for both open-end mutual funds and closed-end funds, is calculated by adding up the value of all the assets the fund owns, subtracting any liabilities, and then dividing that figure by the total number of shares outstanding.
However, closed-end funds are traded on an exchange like a stock or ETF. And rather than paying NAV, investors buy shares at the market price (see note above for details), which changes throughout the day based on supply and demand. That means it's possible to buy a share of a closed end-fund for less than what its underlying securities are worth - in other words, at a discount to its NAV.
Of course, its price can swing in the other direction and sell at NAV or at a premium to NAV. Similar to a stock or ETF, investors can use limit orders to specify the price at which they want to buy or sell shares.Keeping an eye on the long term: It's all about income
Historically, closed-end funds have traded at an average 5.1% discount to their NAV, according to Morningstar Direct. But under certain circumstances, that discount may be even larger. For example, in 2014, the Federal Reserve announced that it was going to begin raising interest rates, which were at historic lows, and start tapering off its quantitative easing policy.
In what was later dubbed the "Taper Tantrum," some investors briefly panicked and fled from investments that use leverage, as many closed-end funds do, causing most closed-end fund discounts to widen. (Leverage may increase distributable income and enhance total return, but will also increase return volatility and risks.) Many investors picked up bargains before the discounts narrowed over the following few years.
Are there bargains still to be had among closed-end funds today? In short, it depends.
Closed-end funds encompass many different kinds of assets, including senior loans, U.S. large-cap equity, global equity and real assets, among others. Even when discounts narrow in certain parts of the market, investors can sometimes find bargains in other areas.
It's important to remember that market prices are driven by a variety of factors, including investor sentiment or perceptions about a fund, asset class or portfolio manager that may not necessarily be based on fact. But more importantly, investors should be focused on the longer-term and the income or distributions that closed-end funds offer.
Closed-end funds are chiefly designed as long-term vehicles for pursuing strong, regular distributions. Even when a fund's discount narrows or it trades at a premium, its distributions can still represent an attractive income opportunity. Focusing on the long-term income potential of a closed-end fund often outweighs the perceived benefit of buying the shares at a discount.