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Why Closed-End Funds Scare Investors

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Smart value investors look for $0.50 deals on dollar bills. Historically, they've gotten some good deals like that on closed-end funds. But with those value propositions evaporating and even turning into expensive disasters waiting to happen, more investors are shying away from the closed-end space.

According to the Investment Company Institute, closed-end funds haven't participated in the general rise in fund assets that has pushed exchange-traded funds above the $1 trillion mark. At $243 billion, closed-end assets are still about 25% less than their peak levels in 2007, and new closed-end fund issuance has come to a virtual standstill. Closed-ends issued just $8 billion in new shares last year, barely a quarter of what they issued four years ago.

What's a closed-end fund?
Back when the traditional mutual fund industry was much smaller and before ETFs even existed, closed-end funds gave investors many of the advantages that ETFs now provide. Unlike regular mutual funds that are open for trade only once a day, closed-ends trade on stock exchanges, making them available to buy or sell anytime the market is open.

One thing that makes closed-ends interesting, though, is the fact that they often trade at a significantly different price from the net value of their assets. Sometimes, share buyers can score some big discounts compared with what the fund's underlying investments are worth. That can provide some bargain opportunities for patient investors who are willing to wait for those discounts to narrow.

A disappearing opportunity
But closed-ends have faced some headwinds lately. On one hand, enough investors have become familiar with the funds that their discounts have narrowed substantially. One analyst says that with many closed-ends selling at discounts of 20% or more during the financial crisis, the average discount now is closer to 3%. That narrow discount simply isn't a big enough bargain to justify the higher costs that many closed-ends impose.

At the same time, ETFs have increasingly encroached on territory once dominated by closed-end funds. For instance, with dividends playing an ever-increasing role in their return expectations, investors are looking closely at master limited partnerships Enterprise Products Partners (NYSE: EPD  ) and Kinder Morgan Energy Partners (NYSE: KMP  ) , with their relatively high yields and tax advantages. Yet while closed-end funds holding MLPs have been popular, ETFs and other exchange-traded products are fighting for market share, with ALPS Alerian MLP (NYSE: AMLP  ) quickly topping the $1 billion mark in assets.

Danger ahead
On the other side of the coin, previously hot closed-ends have cooled off lately, hurting investors. For instance, the Central Fund of Canada (AMEX: CEF  ) , which holds gold and silver bullion, had seen consistent premiums to net asset value during the precious metals boom. But when silver prices plummeted a couple weeks ago, Central Fund shareholders took a double hit, as those substantial premiums turned into discounts of as much as 8%, combining with the drop in the fund's NAV to create outsized losses. Similar fluctuations happened to Sprott Physical Silver (NYSE: PSLV  ) , with a premium of 29% on May 2 falling to 11% on May 4 before rebounding.

Yet even those recent drops haven't reined in other high-flying closed-ends. Two PIMCO closed-ends still command premiums of 50% or more to NAV, while a host of others have less dramatic but still substantial premiums.

Be careful
Closed-ends always have one sure winner: the management companies that run them. From Franklin Templeton (NYSE: BEN  ) and its well-known international offerings to BlackRock's (NYSE: BLK  ) huge stable of equity and bond closed-ends, the fact that investors can't redeem shares directly with fund companies ensures a locked asset base from which to collect management fees. In an era where investors move in and out of funds at a moment's notice, that kind of certainty is extremely valuable.

Closed-end funds still have uses, and you can still find good deals if you look hard enough. But if you just jump into a fund without understanding the fundamentals of closed-ends, you can easily get burned.

Exchange-traded investments like ETFs and closed-end funds can help you find the way to better investing results. To find some great ETF investing ideas, take a look at The Motley Fool's special free report, "3 ETFs Set to Soar During the Recovery."

Fool contributor Dan Caplinger faces the fear of investing. He doesn't own shares of the companies mentioned in this article. Motley Fool newsletter services have recommended BlackRock and Enterprise Products Partners. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy won't scare you.

Read/Post Comments (2) | Recommend This Article (10)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 17, 2011, at 4:33 PM, swlaaggie wrote:

    Agree with nearly every word. However, just like any investment, you have to do your homework. I love CEFs for the outsized distributions but even that requires some homework.

    My personal portfolio is comprised of nearly all CEFs with an average yield north of 7 percent and all trade at discounts ranging from 1-9 percent. Several have outperformed the S&P both in terms of NAV and market price appreciation for the last couple of years.

    Bottom line: Used wisely, these are great investment securities and I highly recommend them given the caveats in your article.

  • Report this Comment On May 17, 2011, at 5:25 PM, xetn wrote:

    I have made multiple purchases (buying on dips) of CEF and each time, I have bought with a discount on nav. CEF's website publishes their nav daily with showing nav and fund price along with the premium/discount in both USD and CDN$.

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