A New Way to Invest in Closed-End Funds

Find me a market niche that's too complex or too small to garner much interest from big investors. Then find me a smart investment team that devotes all its efforts to that niche. The combination is often a recipe for investment success.

Closed-end funds are a perfect niche for talented investors to target. Unlike a regular mutual fund, a closed-end fund typically issues shares just once, when it first goes public. After that, it trades like a stock -- often selling at either a discount or a premium to the value of its underlying assets. U.S. closed-end funds hold only about $200 billion -- a pittance compared with the assets invested in regular funds and exchange-traded funds. And nearly 90% of closed-end assets are in the accounts of individual investors, many of them unsophisticated.

The problem has been finding good managers who focus on this area. The team in charge of RiverNorth Core Opportunity (symbol RNCOX) may fit the bill. The fund, which aims to hold a mix of roughly 60% in stocks and 40% in bonds, has returned an annualized 10.8% over the past three years through March 25. That's an average of 9.5 percentage points per year better than the return of Standard & Poor's 500-stock index. The fund beat Morningstar's typical "moderate allocation" fund by an average of 6.5 percentage points per year over the past three years, too.

From just $107.88 $24.99 for Kiplinger Personal Finance

Become a smarter, better informed investor. Subscribe from just $107.88 $24.99, plus get up to 4 Special Issues

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Patrick Galley, RiverNorth's chief investment officer and the fund's lead manager, strikes me as a savvy, disciplined investor. Galley, 35, co-manager Stephen O'Neill and three analysts start by tinkering with the fund's stock-bond mix. If high-yield bonds or convertible securities, for instance, seem attractive to them, as they did in late 2008, they'll allocate more to those classes and less to stocks.

Next they hunt for bargains among closed-end funds. "Most important," Galley says, "is not to get hung up on a fund's discount" from its net asset value (NAV). "There's nothing to say that the discount will narrow." Instead, the team hunts for a catalyst that could cause a discount to shrink. For example, a major shareholder might be agitating to convert a closed-end fund into a regular mutual fund (which would eliminate the discount), or a closed-end fund might invest in a sector that's becoming more attractive. Or the fund might be selling at a larger discount than usual. "Discounts tend to revert to their average," Galley says.

Buying and selling closed-ends -- many of which trade lightly -- can be difficult. Core Opportunity sets buy and sell targets for the funds, then uses a computer to hunt for trading opportunities. Among other things, the computer figures each fund's discount throughout the trading day based on the prices of the fund's stock and bond holdings. It can take weeks for Core Opportunity to build a full position in a closed-end.

If the team can't find attractively priced funds, they invest in low-cost exchange-traded funds as "placeholders" (the structure of an ETF is designed to prevent it from trading at a discount or a premium to its NAV for long). That kind of discipline impresses me. After all, why take a risk on a closed-end fund if it's not attractively priced?

That individuals are the main buyers and sellers of closed-ends "gives us a huge competitive advantage," says Galley. "People often buy and sell for irrational reasons. You have to get inside the head of individual investors."

One way he does that is by studying dollar flows in and out of stock and bond mutual funds. Recently, for instance, investors have been fleeing municipal bond funds. "And guess what? Discounts on closed-end municipal bond funds are widening," Galley says. The question then becomes: "Am I willing to hold municipal bond funds until they come back into favor?"

RiverNorth's Favorites

What closed-end funds does Galley like now? Royce Value Trust (RVT) is a simple story. Royce closed at $15.16 on March 25, a 13.3% discount to its NAV. Over the past five years, its discount has averaged just 7.7% (for up-to-date discount/premium data and other statistics on closed-end funds, visit www.cefconnect.com). Moreover, the Royce firm is well respected for its record of investing in the small-company stocks the fund targets.

Galley also likes all four Blackrock Credit Allocation funds. The funds are named Blackrock Credit Allocation Income Trust I (PSW), II (PSY), III (BPP) and IV(BTZ). All trade at a 14% discount to NAV, and all invest similarly: 50% in investment-grade corporate bonds, 20% in high-yield bonds, 20% in preferred stocks, and 10% in cash and Treasuries. Even if the discount doesn’t shrink, you’ll collect yields of 6.5% to 7%. All of the funds employ leverage -- that is, they borrow money to boost their bond bets.

All four funds are "earning their yields" -- that is, they're earning enough interest from investments to cover their distributions to shareholders, so they're not distributing capital to shareholders in order to pay their regular dividends. Funds not earning their yields may cut their dividends, a move that typically prompts investors to flee.

Investors often make the mistake of buying a closed-end fund based solely on its yield. "Folks will bid a fund's price up, and the next thing you know you have a Pimco High Income (PHK)." At $13.98, the Pimco fund trades at an astonishing 48% premium to NAV.

RiverNorth recently rolled out a new fund, RiverNorth DoubleLine Strategic Income (RNDLX), to invest solely in income funds. RiverNorth invests a portion of the fund's assets in closed-end funds, and DoubleLine invests the rest of the money in different kinds of bonds. DoubleLine runs the estimable DoubleLine Total Return (DBLTX); for more about it, see Goldberg's Picks: The 4 Best Bond Funds for 2011.

My concern about both RiverNorth funds: I've seen a bunch of talented managers fail at running funds that invest in other funds because of the double layer of expenses. Core Opportunity charges annual expenses of 1.45%, not counting the expenses of the closed-end funds it holds. Strategic Income charges 1.2%.

I think Galley and company may have the smarts and the discipline to overcome their expense handicap. Core Opportunity has assets of $500 million (RiverNorth has $150 million more in similar accounts), and the fund plans to close to new investors soon. I'd take a small position, and see how it does. My hunch is that you won't be disappointed.

Steven T. Goldberg (bio) is an investment adviser in the Washington, D.C. area.

KIPLINGER'S STOCK MARKET MADNESS 2011: Join fellow investors in picking the best stocks to own for the next three years.