Covestor model: Flexible Value
In this volatile environment, many investors are more concerned with protecting their principal rather than finding opportunities across financial markets. Historically, it has been during volatile and uncertain time periods that some of the greatest opportunities have presented themselves. One area that I believe is under-invested is closed-end funds.
Most mutual funds are open-end funds, in which shares always will trade at their Net Asset Value because shares are bought and sold directly from the fund at the end of the trading day (In other words, whatever the experience of the investment fund is also the shareholder's experience).
Closed-end funds are listed on stock exchanges and (unlike open-ended funds) allow investors to buy or sell their shares throughout the trading day on the secondary market. Because their share price is determined by buyer and seller demand throughout the day and not the Net Asset Value of the fund, closed end funds can trade at a premium to (or above) or at a discount (or below) their Net Asset Value.
Buying great closed-end funds when they are trading at substantial discounts is almost always a great idea. I am amazed that there are as many opportunities in this area as there are. This was a strategy that Hedge Fund Legend Carl Icahn used initially in his career. It is a strategy recommended in the book Intelligent Investor by Benjamin Graham.
There are two reasons that this strategy is overlooked by the major brokerage firms. First off, there are limited times when closed-end funds trade at large discounts, typically following a market downturn, so that many firms to not want to spend time educating their employees about a strategy that can only be utilized some of the time. Secondly, closed-ends require significantly more work to manage than an open-ended mutual fund or typical managed money strategies.
Closed-ends can quickly move from large discounts to premiums, and may have to be reevaluated or sold based on these moves. So closed-ends require spread analysis of the price relative to net asset value of the fund analysis in addition to all of the typical research that other funds require.
For these reasons, closed-ends are not scalable solutions for brokerage firms which generally prefer investments which can be bought and held, since this extra work takes more time and effort but pays no additional income to a financial advisor paid based on the amount of assets that they manage.
Given these points, investors should not simply buy every closed-end mutual fund that is trading at a discount. Some closed-ends may be discounted for a reason. They may have precariously high expense ratios, or they may use an excessive amount of leverage. It is important that investors do the same in depth due diligence into the investment that they would do to analyze any other investment.
This would include reviewing: the underlying portfolio of the fund, the historical performance, the management team of the fund, the fund's prospectus and SAI, and the expense ratio and leverage ratio. Keep in mind that the degree of risk assumed due to the leverage ratio may vary depending on the underlying fund holdings.
For example, it is less risky to employ leverage when investing in high quality mortgages with short-term maturities backed by government sponsored entities than to use leverage to buy Micro-Cap Stocks. One can research closed-end funds and their discounts or premiums at Morningstar.com. I have found significant opportunities in this area since the financial crisis.*
(This is an excerpt from Daniel Beckerman's upcoming Book Turbulence Investing ™)*
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