By Dan Caplinger | September 21, 2012
The Motley Fool has been helping ordinary people become better investors for nearly two decades. This month, we're reaching out to millions of investors to help guide them in their quest toward financial knowledge and independence.
Along those lines, I'm planning to take a look at different ways for investors to put their money to work in the market today. In particular, exchange-traded funds have skyrocketed in popularity, but even before ETFs were available, there was a similar investment with some intriguing twists. Today, I'd like to take a broad look at closed-end funds and how you can integrate them into your portfolio.
Long before ETFs became available, closed-end funds gave investors many of the same benefits. Like ETFs, closed-ends trade on regular stock exchanges, letting you buy and sell shares whenever the market's open. Closed-ends also have diversified portfolios of underlying assets, letting you get exposure to a group of stocks or other investments in a single package.
Unlike ETFs, though, closed-end funds have a limited number of shares outstanding. As a result, supply and demand play a much bigger role in pricing for closed-ends than they do for ETFs. Popular closed-end funds can trade at big premiums to their net asset value per share, while those that are out of favor can trade at substantial discounts. Because the fund company doesn't play a role in redeeming or creating new shares at will, premiums or discounts can persist for months or even years.
In fact, some of the most popular closed-ends on the market trade at ridiculous premiums. The PIMCO High Income Fund (NYSE - PHK), which is managed by bond guru Bill Gross and owns a broad set of high-yield corporate bonds, has a share price that's almost 70% higher than the per-share value of its underlying assets. Another fund from the same company, PIMCO Global Stocks Plus (NYSE - PGP), combines asset-backed, corporate, and government bonds with stock futures contracts and options to give a mix of income and equity exposure. It too has a high premium of almost 65%.
For the most part, though, you'll typically find much more modest premiums or discounts. Central Fund of Canada (NYSE - CEF) is a bullion-owning closed-end fund with about equal-value holdings of gold and silver, and it trades at a mere 5% premium -- one that many justify by citing its potential tax advantages over similar bullion ETFs. Similarly, international bond closed-ends Aberdeen Asia-Pacific Income (NYSE - FAX) and Templeton Global Income (NYSE - GIM) have premiums in the 2% to 3% range and open up the bond markets of foreign countries around the world to investors.
The main benefit of closed-end funds is also its biggest potential liability: obscurity. Trading in most closed-ends is extremely illiquid, with relatively few buyers and sellers available at any given time. As a result, it's critical to be patient if you're a closed-end investor, as even small orders for a few thousand dollars can end up moving share prices substantially. Also, bid-ask spreads tend to be very wide, rewarding those who use limit orders to open positions rather than trying to execute a market order and hoping that they get a fair price.
At the same time, though, the illiquidity of closed-end funds gives you opportunities to capitalize on those with less patience. Often, a closed-end may see little or no share volume for days, only to experience a brief spurt of activity. Typically, that activity pushes the market sharply in one direction or the other, letting you take the other side of the trade and potentially reap a big profit.
One downside of closed-end funds is that they tend to have relatively expensive management fees. While standard mutual funds have fees of about $100 for every $10,000 you invest, it's not unusual to see closed-ends charge $150 to $200 for a similar investment.
Despite the risks and downsides, closed-ends are one place where even small investors can have a big edge. To learn more about closed-end funds, I recommend taking a look at Nuveen's CEF Connect website, which provides information on just about every fund in the closed-end universe.
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