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In the quest to find the perfect investment, value investors look to pay $0.50 for a dollar's worth of assets. With many closed-end funds, however, buyers who are desperate to find high-yielding investments are doing exactly the opposite -- and sometimes, they end up paying the consequences.
This week was one of those times, as several high-yielding closed-end funds suffered big drops in light of an article in Barron's that highlighted an issue that the Motley Fool has tried to drill down on again and again. Later in this article, I'll explain exactly why these funds fell, but first, let's get a refresher on exactly what closed-end funds are and why they're vulnerable to situations like this.
Closed-ends and you
Closed-end funds were the predecessor to modern-day exchange-traded funds. Even before ETFs were invented, closed-ends gave investors a chance to own diversified investment vehicles while being able to buy and sell shares during trading hours on major stock exchanges.
Closed-ends combine some favorable elements of mutual funds and ETFs. Like traditional mutual funds, closed-end funds offer a wide range of investments, with some funds focusing on particular niche areas while others give investors broad exposure to an entire market. Unlike mutual funds, however, you don't have to wait until the end of the day to buy or sell shares.
The difference between closed-ends and ETFs is a little more subtle, but it's also vitally important. With ETFs, financial institutions known as authorized participants have relationships with the company that manages the ETF that allow them to buy and sell large blocks of ETF shares directly from the ETF manager. That market mechanism typically keeps ETF share prices relatively close to the underlying value of the ETF's assets, because if the disparity becomes too wide, authorized participants can profit from an arbitrage opportunity by either creating or redeeming ETF shares.
Closed-ends, on the other hand, don't continuously offer new shares. The supply of shares from day to day is entirely determined by investor supply and demand, and because there's no effective short-term way to cash in on discrepancies between a closed-end's net asset value and its trading price, closed-end shares can trade at big premiums or discounts to NAV for a long time.
The Barron's article this past weekend looked at closed-end funds that pay extremely high yields. Using a combination of leverage and high-yield bonds, Pimco High Income (NYSE: PHK ) has paid shareholders distributions that amount to about 12% of its current share price over the past year.
But as the article noted, the prevailing share price was a full 70% higher than the fund's net asset value. Hunger for income likely drove shares to the huge premium to NAV, but the article did a good job of collapsing the share price. Shares have lost 15% this week alone, still leaving the fund trading at a steep 40% premium. Several similar funds that the article mentioned have seen similar drops.
The big question is why it took a Barron's article to make this happen. Yet with bond funds, it's somewhat more understandable that premiums might persist, because it isn't a trivial process to duplicate a bond portfolio on your own. Holding debt from AIG (NYSE: AIG ) , Barclays (NYSE: BCS ) , and Capital One (NYSE: COF ) among many others, Pimco High Income isn't using its size and prestige to buy a bunch of obscure and highly profitable issuers that no one else can invest in. Yet while you could also have earned a lot by investing in bonds of big banking and insurance institutions as they recovered from the financial crisis, it would still be tough for you to buy the roughly 315 different bonds the fund holds on your own.
Some closed-ends also offer tax advantages that justify a premium. The closed-end Central Fund of Canada (NYSEMKT: CEF ) , for instance, owns gold and silver bullion like many other ETFs, but it's structured in a manner that qualifies it for favorable taxable gains treatment. Yet it usually sports a modest premium of around 5%.
Although shares have fallen back, episodes like this have happened before, with new investors coming in to bid shares back upward again. Before you buy into any investment offering a big yield, be sure you know the risks. Otherwise, you could end up getting burned.
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