Invest at a Double Discount

After the shellacking that stock markets around the world have taken recently, you can find nearly any stock you're interested in at prices that would've seemed impossible not too long ago. By using a little-known investment method, though, you can actually double your discounts -- and get in on some great opportunities.

Closed-end funds aren't as well-known as their more famous cousins, exchange-traded funds. Like ETFs, closed-end funds trade on public exchanges just like stock, rather than directly through fund companies, as traditional mutual funds do.

But closed-end funds have one distinct advantage over ETFs that's especially useful in a perilous investing environment like this. Because of their unusual structure, closed-end funds don't have the same liquidity needs as mutual funds and ETFs.

No redemption, no return
Securities laws require traditional mutual funds to allow investors to redeem shares at their net asset value. As a result, fund managers must always be ready to satisfy redemption requests. That can limit a manager's ability to take advantage of adverse market conditions -- especially if it requires taking illiquid positions that can't be reversed easily.

ETFs have somewhat more flexibility. But most still allow large institutions to create and redeem large blocks of shares directly through ETF management firms. Although ETFs can satisfy these requests by delivering either cash or securities, it still means that they must remain responsive to investor cash flows.

In contrast, after their initial public offerings are complete, closed-end fund shares trade only in the secondary market. Fund managers don't have to worry about redemption requests and can instead invest for the long haul if they're so inclined.

Unusual discounts
Ironically, because shareholders can't redeem shares to get cash directly from fund managers, closed-end funds often trade at a discount to the intrinsic value of their assets. That gives investors a chance to buy in cheaply.

Lately, some of those discounts have been above average. Consider:

  • High-yield bond funds are available at discounts as high as 35%.
  • Several municipal bond funds are trading at 20-25% discounts.
  • Closed-ends focusing on international stocks have also gotten beaten down, with the First Israel Fund (ISL) trading at more than a 20% discount despite holding shares of well-known companies such as Teva Pharmaceuticals (Nasdaq: TEVA  ) and Perrigo (Nasdaq: PRGO  ) .

In addition, funds that focus on U.S. stocks also trade at some wide discounts. Here are just a few:

Fund

Current Discount

1-Year Market Return

Top Holdings Include

Adams Express (ADX)

20.8%

(39.6%)

General Electric (NYSE: GE  )
Microsoft (Nasdaq: MSFT  )

Petroleum & Resources (PEO)

10.3%

(38%)

Chevron (NYSE: CVX  )
Schlumberger (NYSE: SLB  )

Foxby (FXBY)

39.7%

(77.1%)

T. Rowe Price
Teck Cominco (NYSE: TCK  )

Source: Closed End Fund Association.

In just about every asset class you can think of, there are bargains to be found. But make sure you don't get trapped by a fund that isn't as attractive as it may look.

How to pick a closed-end fund
If you're used to working with ETFs and traditional mutual funds, closed-ends have some quirks. Here are some tips for choosing a good one:

  • Get specific. The nicest thing about closed-ends is that they let you focus very narrowly on certain types of investments, while not necessarily being tied to an index, like a sector ETF is. So find the fund that most closely matches the investments you're looking for.
  • Watch the fees. Because many closed-end funds are small, they lack economies of scale. That can push expense ratios to very high levels. As with any other fund, paying high fees on a closed-end fund jeopardizes your profit potential.
  • Look at history. Most funds traditionally trade at discounts. So don't let a current discount trick you into thinking a fund is a bargain -- that discount could widen. Moreover, there may be a good reason a particular fund is discounted heavily -- one that bodes ill for shareholders.
  • Diversify. The sheer number of different funds covering a wide array of asset classes lets you diversify your fund portfolio broadly. Take advantage of that situation to fill in gaps in your other investments.

A word of warning
Finally, bear in mind that because closed-ends trade on the open market, they're subject to market fluctuations. During volatile periods like this one, you can see your fund shares fluctuate wildly -- more wildly than shares of large-cap companies that trade with more liquidity. Over time, however, closed-ends generally track the performance of their underlying assets.

So if you want to take advantage of double discounts while they last, check out closed-end funds. You may find exactly what you're looking for.

For more on making the right moves in your portfolio, read about:

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Fool contributor Dan Caplinger likes closed-end funds. He owns shares of Petroleum & Resources, as well as General Electric. Microsoft is a Motley Fool Inside Value pick. Try any of our Foolish newsletter services free for 30 days. The Fool's disclosure policy is absolutely free -- you can't get a better discount than that!


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