In the first part of this article, you learned the basics of closed-end mutual funds and some of the ways they differ from traditional mutual funds. Because closed-end funds have a fixed number of shares and trade only on stock exchanges, there are potential opportunities and pitfalls for people who invest in them.
Bargains and markups
Once a closed-end fund finishes its initial public offering of shares to initial investors, the fund becomes available for trading in the secondary market. Because it's in the best interest of the fund to sell as many shares in its IPO as it can, the fund often exhausts its demand during the subscription phase. Therefore, share prices often fall once they begin to trade, since anyone who wanted to buy the shares could do so in the initial offering.
Like other mutual funds, however, closed-end funds calculate their net asset value per share on a regular basis, usually daily or weekly. The net asset value represents each share's portion of the total value of the fund's investments. For those closed-end funds that primarily invest in securities that trade on public financial markets, the net asset value provides an excellent approximation of intrinsic value. Investors in closed-end funds therefore have to focus on two different prices: the net asset value that gives the theoretical intrinsic value of the shares, and the market price that reflects the actual amount that buyers would be willing to pay for those shares.
You may be thinking that these two prices would stay close to each other. However, there are a variety of factors that may cause closed-end funds to trade significantly above or below their net asset value. In some cases, the relative popularity of a particular fund's investment objective may contribute to a significant disparity between net asset value and market price. For instance, in recent years, investing in fast-growing markets like Russia, China, and India has become extremely popular, and closed-end funds like Templeton Russia Fund (NYSE: TRF ) , China Fund (NYSE: CHN ) , and Morgan Stanley India Investment Fund (NYSE: IIF ) have often traded at high premiums relative to their market value. On the other hand, with the fear that real estate prices have peaked and may face steep price declines in some markets, many closed-end funds that invest in real estate, such as Neuberger Realty Income (NYSE: NRI ) and AEW Real Estate Income Fund (AMEX: RIF ) , trade at double-digit percentage discounts to their net asset values.
One might also think that discounted share prices would invite large investors to buy out entire funds to reap a quick profit. In fact, there have been several attempts by investors to force closed-end funds to convert to open-end funds, including the successful conversion of the Salomon Brothers Fund. However, as with the Putnam Premier Income Trust (NYSE: PPT ) , most proposals to convert closed-end funds fail. In response, many fund companies will take less extreme measures to try to eliminate discounts, such as buying back a limited number of fund shares.
Tips for investors
Even though you can't expect immediate profits from closed-end funds, patient investors can use fund discounts to their advantage. By following a contrarian philosophy of buying types of assets that are out of favor, you can purchase shares of closed-end funds at a deep discount and wait for the asset class to become more popular, in the hopes that increasing popularity will reduce the discount and add to your overall return. Discounted closed-end fund shares offer two ways to make money: If either the value of the fund's assets rises or the discount percentage decreases, then the market value will usually rise. If both of those things happen, then you'll often earn an exceptional return.
On the other hand, it rarely makes sense to buy a closed-end fund at a premium to net asset value. Because open-end mutual funds always allow you to buy shares at net asset value, you should try to find a similar open-end fund rather than pay a premium for a closed-end fund. Furthermore, closed-end funds sometimes take advantage of high fund market prices by making secondary offerings of new shares to investors, which can dilute the interests of existing shareholders and cause the market price to fall toward net asset value.
Similarly, you should usually wait until after the initial subscription period to buy closed-end fund shares. Initial shareholders pay not only full net asset value but also whatever sales charge the offering company adds to the cost as an incentive for stockbrokers and other financial advisors to sell shares. Buyers in the secondary market avoid these added costs.
Finally, keep in mind that you should use the same tools to evaluate closed-end funds that you use for any mutual fund. It's important to choose an experienced manager with a history of good performance. In addition, keeping fund expenses low is critical to ensuring that you don't sacrifice too much of your investment return to overhead and other costs. High expenses are a common problem among smaller closed-end funds. With fewer assets in relation to their fixed costs, the fund must take a higher percentage of those assets each year in order to pay for its continuing operations. The Closed-End Fund Association provides a large amount of data on closed-end mutual funds, including information on managers, expenses, and market price premium and discount figures.
Closed-end funds may not be the only investment you want to make, but they provide a useful addition to your arsenal of available investment options. By using closed-end funds as a portion of your portfolio, you may be able to take advantage of their unique characteristics to earn above-average returns.
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Fool contributor Dan Caplinger likes buying dollars for dimes but rarely gets the chance. He invests in a number of closed-end funds but doesn't own shares of any that are mentioned in this article. The Fool's disclosure policy is always open to you.