Closed-Ended Funds...Buy Assets at a Discount
At its core, investing is a lot like grocery shopping. Both are exercises in obtaining maximum utility while operating within certain constraints. Whereas grocery shoppers may try to achieve a healthful diet for a minimal outlay of cash, investors are typically interested in either maximizing profit for a given level of risk, or minimizing risk for a given level of profit.
When the price of a particular grocery item is priced below its normal selling price, shoppers instinctively recognize the value and buy more of it. In the context of investing, however, the notion of capturing additional value by securing a discount is less instinctive.
What if one could buy into an investment portfolio and pay, say, only 85 or 90 cents for each dollar’s worth of assets? In the world of "closed-ended" mutual funds, one often can. Unlike traditional "open-ended" mutual funds where shares are issued and redeemed by the funds themselves, the shares of closed-ended funds are generally bought and sold among investors in public securities markets. Whereas the shares of traditional, open-ended funds are usually priced at their underlying value (called net asset value) each business day, the shares of closed-ended funds often trade at prices that differ materially from their underlying values. Here’s the key: Although closed-ended funds may trade at premiums or discounts to their underlying values, in practice they tend to trade at discounts more often than not. Therein lies the opportunity.
Assume a mutual fund holds a portfolio that generates income of 6% per year net of fund expenses. If that fund is organized as an open-ended fund, its pass-through yield (before operating expenses) would be that same 6%. If, however, that fund were organized as a closed-ended fund and one were able to purchase its shares at, say, a discount of 15% to its underlying value, the fund’s pass-through yield would increase to over 7%. That’s a raise of 17%!
Buying at a discount has its advantages. As such, closed-ended funds may be worth a look.
