3 Valuable Lessons From an Obscure Corner of the Market

Most investors concentrate on the best-known stocks in the market. But by looking beyond the ordinary run-of-the-mill companies that everybody knows about, you can find some insight on prevailing trends that you might otherwise never notice.

One little-followed niche investment is the closed-end fund. These predecessors to exchange-traded funds differ from traditional mutual funds in that they trade on stock exchanges throughout the market day. Yet unlike ETFs, they have only a fixed number of shares available, making the funds subject to supply and-demand pressures. As a result, you can tell which areas are hot and which are cold just by looking at whether investors are willing to pay a premium for shares compared to their net asset value, or whether buyers are only willing to pay a discounted price for shares.

Let's take a look at three interesting conclusions you can draw from the current state of the closed-end fund market.

Lesson 1: Income is king.
A look at the four funds trading at the highest premiums to net asset value reveals a common thread: They're all focused on maximizing income. What's interesting, though, is that they use different methods to reach the same ends. Among the three PIMCO funds, PIMCO High Income (NYSE: PHK  ) looks largely to the high-yield bond market for its holdings, while PIMCO Corporate & Income Opportunities (NYSE: PTY  ) has a somewhat lower distribution rate but has a sizable allocation to investment-grade debt. The fund with the highest premium, PIMCO Global StocksPLUS, uses futures contracts to add stock exposure to its portfolio of income-producing bonds. Finally, BlackRock Virginia Municipal Bond rounds out the top four with its tax-free bond portfolio.

With premiums ranging from 27% all the way up to 56%, investors are clearly willing to pay up for these funds' big distributions, even when their portfolios aren't able to generate enough actual investment income to cover what they pay out. It may seem inevitable that investors will figure out they're overpaying, but so far, those premiums have persisted for a long time without signs of disappearing.

Lesson 2: Leverage is plentiful.
All four of the closed-end funds above share another common trait: They all use leverage to boost their returns. By getting cheap financing and using the proceeds to buy higher-returning securities, closed-end funds can boost their investment returns.

That's the same strategy that has led to such strong gains for mortgage REIT Annaly Capital (NYSE: NLY  ) . But like Annaly, these closed-ends rely on low borrowing rates to generate the spreads necessary to create bigger profits. If interest rates rise, the high leverage levels in closed-end funds may backfire.

Lesson 3: Europe is unloved, but is it a value?
On the other side of the popularity coin, looking at a list of funds trading at big discounts to their net asset value reveals many closed-ends that focus on Europe. With discounts of more than 10%, funds covering Switzerland, Ireland, Turkey, and Germany, as well as broader-based central and eastern European funds, have drawn little interest from investors lately.

You can see the same trends among many individual European stocks. Telecom giant Telefonica (NYSE: TEF  ) has big exposure to Latin America, but investors focus on its home country of Spain in limiting its gains. The same trend has affected French oil giant Total (NYSE: TOT  ) , which shares the same exposure to energy projects around the world yet has been tarnished by its proximity to the crisis-ridden continent. By focusing on value rather than perception, you can get some great values when others are being irrational.

Don't stop searching
You may never decide to buy shares of a closed-end fund for your own portfolio, but that doesn't mean you shouldn't pay attention to the closed-end market. Studying various corners of the investment world can give you extra information compared to those who merely focus on the biggest headlines.

There's no question Annaly Capital's double-digit dividend is eye-catching. But can investors count on that payout sticking around? With the Federal Reserve keeping interest rates at historically low levels, Annaly has had to scramble to defend its bottom line. In The Motley Fool's premium research report on Annaly, senior analysts Ilan Moscovitz and Matt Koppenheffer uncover the key challenges the company faces and divulge three reasons investors may consider buying it. Simply click here now to claim your copy today!


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  • Report this Comment On May 10, 2013, at 8:52 AM, cloudofjoy wrote:

    I am a novice investor and your article is exactly what I preach to my close friends, and family. I have been involved with PHK for a long time, but pulled out a year ago to move on to other high dividend paying Close end funds. The fact that the funds are over extending themselves has kept in interested in the funds that are healthy enough to possibly survive a hike in interest rates.

    I am a small time investor, but all of it is done under the tax shelter of a ROTH. So in years that I yielded 30% return on my investments, it was a tax free 30%. This year it might be hard to hit 30%, because my methods make me stop when the market is moving too fast, like now. the process is to buy high yield funds, wait for Xdiv, then wait for the price to go up, or the next dividend. if the price goes up, sell on 2 or 3 times dividend. the odds that I can get it back at a lower price within those three months are usually very good. I hardly ever miss a dividend, and I get the capital gains several times a year. This process has been working for me for 8 years. My uncle , who can't read, or write, at least not in any way that would impress a 3rd grader, plays options, and does really well. He uses a broker to do all the transactions by his instructions over the phone. He tried to get me interested in option trading. What I know is that there are a lot of ways to make, and lose money in the stock market. My advice is to stick with what you understand, and don't get greedy. Thanks for the great article Dan.

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