Outrageous Opportunities in Closed-End Funds
If the stock market has been like a roller coaster the past month, the universe of closed-end funds has been like a roller coaster on crack. Share prices for almost all 650 closed-end funds have been swinging more wildly than the prices of the assets they hold. That makes closed-ends extra scary in these uncertain times, but it also creates fabulous opportunities for investors with an appetite for risk.
One of the main reasons for the extra dose of volatility is the use of leverage, which many closed-end income funds employ to boost yield. Other key factors are the structure of closed-end funds and the temperament of closed-end-fund investors. Says Cecilia Gondor, of Thomas J. Herzfeld Advisors, one of the premiere investing firms specializing in closed-ends: "It's typical of closed-end-fund investors to overreact to bad news."
A glimpse at the yields of some closed-end bond funds will make your jaw drop (check www.etfconnect.com). Some of the figures, which are based on the previous 12 months' distributions, top 50%. Throw in the fact that the shares of many of these funds sell for well below the value of the funds' underlying assets, and there seems to be an abundance of screaming buys. Screaming is the operative word here -- as in riding that crack-fueled, could-jump-the-tracks-anytime roller coaster.
But before we get ahead of ourselves, here's a quick primer on closed-end funds: Unlike regular mutual funds, closed-ends issue a set number of shares and trade like stocks on exchanges. Closed-end-fund shares can sell for roughly the value of the fund's holdings, expressed as the fund's net asset value (NAV) per share, but this rarely happens. Most of the time, the funds trade at discounts to their NAV (this distinguishes closed-end funds from their younger cousins, exchange-traded funds, which feature mechanisms that generally keep their share prices near NAV). Closed-end-fund shares sometimes sell above NAV, but only suckers and speculators buy funds selling at premiums to NAV -- it's like paying $11 for a $10 bill.
Consider, for example, SunAmerica Focused Alpha Growth (symbol FGF), a growth-stock fund run by two highly regarded investors, Ron Baron and Tom Marsico. On October 10, the last day of Crash Week, its NAV per share closed at $12.13 and its shares closed at $9.02, so the shares finished the week at a 26% discount to NAV. But for the previous three years, the discount had ranged from 9% to 15%. The shares closed October 15 at $9.86, down nearly 8% (the closing NAV was not immediately available).
The point, though, is that if you buy a fund such as this one at a super-wide discount, chances are good you will benefit as that discount narrows.
Just how skittish have closed-end-fund investors been lately? On October 10, shares of RMR Preferred Dividend (RDR), a leveraged income fund, closed at $1.68. But by the close on October 14, they had risen 57%. The shares rose another 3%, to $2.71, on October 15.
Here's a broader way to look at it: The average discount to NAV for closed-end funds is ordinarily about 4%. On October 13, it was 16%, according to Gondor. She says the volatility has been so crazy that you could have bought a closed-end fund at a discount to its NAV, and a couple days later be holding it at a premium based on the price you paid -- though the fund itself would still be trading at a discount.
The market volatility is a boon to traders of closed-end funds. Gondor says aggressive investors consider buying funds that are at a particularly wide discount within a group. Closed-end funds fall into about a dozen categories or asset classes, including general equity, world equity, investment-grade bond and high-yield bond. Two of the most popular categories are national and single-state municipal bond funds.
But for long-term investors, the trick is finding some assets you like and buying them at a discount, Gondor says. Some suggestions on funds that fit that bill in a bit.
First, though, you should understand the changing mood of the closed-end market. Alexander Reiss, a closed-end analyst for Stifel Nicolaus, says he expects discounts to shrink as investors conclude that overall market risk has dropped as a result of aggressive government actions to stem the credit crisis. "We are now going to move from people being worried about everything to being worried about individual asset classes," he says. That's refreshing, Reiss adds, because lately investors have been focusing on "huge issues."
Reiss is particularly bullish on covered-call stock funds, which he says have "excellent risk-reward characteristics." With these funds, managers buy stocks, then generate extra income by selling call options (which give the buyer the right to purchase a security at a certain price for a limited amount of time) on those stocks. This "covered-call" strategy usually helps steady a fund's returns. Reiss likes Nuveen Multi-Strategy Income and Growth Fund (JPC) and Nuveen Multi-Strategy Income and Growth Fund 2 (JQC). Based on each fund's past four quarterly distributions and their closing share prices on October 14 of $5.00 and $5.10, respectively, each yielded a shade less than 22%. Their respective discounts to NAV were 23% and 25%.
Don't count on actually receiving that much, however. Distributions from a covered-call fund aren't as steady and predictable as dividends from a bond fund. To make the distributions, a closed-end fund has to make money from its investments. If a fund doesn't earn enough to cover the payout, it can either reduce the distribution or invade principal, which will hurt the fund's NAV. That, in turn, is likely to affect the share price.
In the muni-bond area, Reiss likes Morgan Stanley Quality Municipal Securities (IQM). At its October 14 closing share price of $9.15, the fund, which is leveraged, yields 7.9% and trades at a whopping 21% discount to NAV. That's about ten percentage points greater than the discount that prevailed for most of 2008.
Two closed-end stock funds that we've recommended in the past are also trading at deeper discounts. General American Investors (GAM) is a conservative fund, established in 1927, that invests mainly in large, growing companies that sell at reasonable prices, then holds them for years (annual portfolio turnover is usually less than 20%).
The fund's recent performance is, not surprisingly, dismal. Over the past year through October 14, its shares have lost 47%; over the past five years, they've returned nothing. But if you factor out the current madness, consider that through May of this year the fund had returned 15% annualized since 1995. At its October 14 close of $20.29, General American traded at a 15% discount to NAV. (The shares closed at $18.95 on October 15, down 6.5%.)
Another stock fund with a long history is Central Securities (CET). Central, which was founded in 1929, has been run since 1973 by Wilmot Kidd, who likes to invest in companies of all sizes. Because managers of closed-ends don't have to worry about shareholder redemptions (or, for that matter, inflows of new money), Wilmot has the luxury of being able to invest some of the fund's assets in privately held companies and to be able to look out three to five years.
Over the past year through October 10, the fund's shares have lost 26%. Over the past five years, they've returned a respectable 7.4% annualized. Central discloses its NAV weekly. At their October 10 close of $17.61, the shares traded at a 19% discount to an NAV of $21.75 per share, about five percentage points greater than normal. The shares closed at $19.01 on October 15, down 5.3% for the day.