Volatility With a Potential Payoff
Sunday, November 5, 2006
NEW YORK -- Closed-end funds have the misfortune to carry a name that connotes exclusivity, certainly not the more egalitarian overtones of a term like "mutual fund." But closed-end funds are not the exclusive province of Wall Street insiders and can be as much an everyman investment tool as mutual funds.
Closed-end funds are like mutual funds in that they invest in securities such as bonds and stocks to give investors an easy way to help diversify their holdings. Both have managers who oversee and make changes to the holdings and both charge fees.
The term "closed-end fund" refers to the way these structures are created. Money is raised in an initial public offering and then the fund is essentially capped. That pool of money is invested and people are free to buy and sell shares of closed-end funds as easily and frequently as they would stocks. In a mutual fund, new shares are continually being issued as new investors come along.
Moreover, unlike a mutual fund, the sales of shares in a closed-end fund do not affect the fund's assets. The fund manager does not have to worry that investors might pull their money from the fund and can perhaps more easily execute a long-term investment strategy.
While closed-end funds are not suitable for everyone, savvy investors with a tolerance for volatility can perhaps profit by taking advantage of the lower profile that closed-end funds tend to have -- generally, they are geared toward investors seeking income, not big institutions looking for capital appreciation.
"The big sharks are not swimming with you," said Alexander Reiss, a closed-end fund analyst at Ryan Beck & Co. He contends the limited presence of big investment houses can make it easier for a diligent investor to compete in this arena.
Another important difference is that closed-end funds almost always trade above or below the value of the assets that make up the fund. This is referred to as the premium or discount. The share price of mutual funds, however, simply reflects the value of the fund's holdings. Shifts in premiums or discounts do make some investors nervous.
As closed-end funds often change hands at a discount to their net asset value, there is sometimes money to be made. This discount often reflects overall investor sentiment but also the types of risks taken on by closed-end funds, which frequently invest borrowed money to enhance returns. One of the risks in using a leverage strategy, however, is that interest rates can change and eat into a fund's returns.
In the second quarter, many highly leveraged funds fared poorly as interest rates rose. "Those funds that had a lot of leverage in them, they basically tanked," said Tom Roseen, an analyst at Lipper Inc., which tracks funds.
"Though we had an absolutely dismal quarter for closed-end funds in the second quarter, the third quarter was great," he said.
Roseen cited the case of closed-end funds that focus on real estate. In the second quarter, their net asset value fell 1.38 percent over all, while their share price fell 1.4 percent. But in the third quarter as the commercial real estate market remained robust and the Federal Reserve interrupted a two-year string of interest rate hikes by leaving rates unchanged, net asset value of real estate funds rose 9.69 percent. At the same time, their share prices jumped 14.14 percent.
John Miller, manager of funds management at Nuveen Investments LLC, the largest player in the closed-end fund world, said all 21 categories of closed-end funds Nuveen monitors showed improved share prices and net asset value returns in the third quarter. And all but one category showed the share price outperform the increase in net asset value.
Nuveen's preferred and convertible income fund, for example, saw its share price increase 14.81 percent while its net asset value rose only 6.24 percent.
Roseen questions whether closed-end funds have much room left to run and said those considering investing in them should look for funds trading at a discount to net asset value. "I'm wondering if the party is not already over," he said.
While Miller suggests investors carefully consider whether to hold onto funds trading at premiums, he contends there is still a window in which investors can profit from the discounts on some funds. The opportunity stems from the notion held by some investors that the Fed is done raising interest rates and that its next move, perhaps next year, will be to cut rates. Should that occur it is likely the discounts in share prices to net asset value would shrink or perhaps convert to premiums.
Miller said that as demand for municipal bonds has risen and sent prices higher a number of closed-end funds focused on municipal bonds still trade at discounts. Investors generally seek municipal bonds for their security and reliable income.
So what should investors weigh when considering a closed-end fund? First, they need to examine the types of assets the fund invests in and the quality of those investments. While there are various permutations of each, there are 447 closed-end funds that invest in bonds and 233 that invest in equities, Lipper said.
Miller said investors need to determine whether the fund they are considering uses borrowed money and whether it is trading at a premium or a discount to its net asset value. Of course, investors also should look at the fund manager's track record.
Reiss also encourages investors to do their homework. "You don't want to have all your money concentrated in one investment ever. For new investors, they should test the waters."