By Scott Burns
Photography by RJ Hinkle of Quad Photo
How would you like to buy a dollar of investments for 85, 90, or 95 cents? You can. You can do it every day. It’s about the closest thing to free money going. All you have to do is get familiar with the original Exchange Traded Funds, the small world of closed-end funds. While Exchange Traded Funds get all the attention, closed-end funds routinely offer interesting opportunities.
Just don’t expect a printed invitation.
While the burgeoning universe of ETFs has soared to more than 194 funds with more than $322 billion in assets in only 13 years, a universe of 710 closed-end funds has gathered only $232 billion in assets in a history that stretches back more than 70 years. Like ETFs, closed-end funds are portfolios that trade like a stock. Like ETFs, closed-end funds can specialize in municipal bonds, junk bonds, foreign stocks, and particular sectors of the stock market.
Unlike ETFs, closed-end funds can trade at wide discounts (and premiums) to the net asset value of the underlying portfolio. That’s what creates the opportunities for you and me. There are different theories for why these funds often sell at a discount. Some say they lack brokerage firm attention after being launched. Others say the discount reflects the tax liability in unrealized capital gains some of the funds have. Still others say the discount might result from high expenses, poor performance, or both.
What’s important is that deep discounts bring moves to convert the funds to open end, and you and I have regular opportunities to buy low and sell higher. Even if we don’t sell, buying assets at a discount can work to provide us with higher yields and/or the equivalent of free money management.
How’s that?
Suppose a portfolio of stocks has a dividend yield of 2 percent and you can buy the portfolio for 85 cents on the dollar. That means you get a yield of 2.35 percent. In today’s investment-income-starved world, every little bit helps. This is particularly good when you participate in a dividend reinvestment plan. The larger dividend buys more shares at a discount. Then again, you could view the discount as a subsidy for the cost of management. While ETFs are celebrated for their low cost relative to managed mutual funds, sporting expenses as low as 9 basis points or .09 percent a year, some closed-end funds could be considered to have free or even subsidized management.
How? If you buy $1 of assets for 85 cents, you’re getting the earning power of the other 15 cents for nothing. If a fund earns 10 percent a year and costs 1.5 percent to manage, that 15 cents you didn’t pay for is earning 1.5 percent — enough to pay the entire cost of managing the fund.
The CEF game, if you want to play it, has simple rules. First, never buy a closed-end fund when it is issued: You’ll pay a hefty premium and most funds eventually sell at a discount. Second, use the Web sites that report on CEF pricing — The Wall Street Journal and Morningstar both present historical graphs. Buy when the discounts are average or higher.
Scott Burns (www.scottburns.com) has been a personal finance writer since 1977 and has been syndicated in newspapers across the United States since the late 1980s. Send your questions and comments about managing your wealth via e-mail to privateclubs@clubcorp.com.
Here we provide a few Web sites that report on CEF pricing.
• The Wall Street Journal (go to Markets, Market Data Center, and Closed-end funds under “Mutual Funds and ETFs”
www.wsj.com
• Final URL for WSJ listings
http://online.wsj.com/documents/CEFmain.html
• Morningstar (enter “Closed-end funds” in search to find news)
www.morningstar.com
• Closed-end fund association
www.closed-endfunds.com/
• Private Clubs/”Ready Money”: “The ETF Revolution,” January/February 2006
www.privateclubs.com/archives/2006-jan-feb/life_ready-money.htm