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With the rapid rise of the ETF revolution over the past two decades, closed-end funds have fallen out of the limelight. But even though exchange-traded funds seem to get all the attention, closed-end funds still have a number of advantages that ETFs don't, and smart investors can take of those benefits to improve their overall returns.
Tradable before trading was cool
Long before ETFs were even invented, closed-end funds offered many of the characteristics that investors like most about ETFs. Unlike traditional mutual funds, closed-ends trade on public exchanges, allowing investors to buy and sell shares of the funds throughout the trading day. You could use closed-end funds to get diversified exposure to dozens or even hundreds of different companies even with just a modest investment in fund shares. Moreover, like the newest active ETFs, closed-end funds aren't locked into tracking a certain index, instead having fund managers who actively seek out the best investments and who make changes from time to time to their portfolios.
But closed-end funds have some unique attributes that neither traditional mutual funds nor ETFs share. Most mutual funds and ETFs have potentially unlimited numbers of shares, with mechanisms in place to make sure that if investors drive up demand for a particular type of fund, the company that manages the fund will create additional shares to meet that demand. By contrast, closed-end funds only issue new shares through the public offering process, meaning that except for well-telegraphed situations, the share count for closed-end funds is fixed at a particular number.
Grabbing up value opportunities
Fixed share counts mean that prices of closed-end funds are driven not just by the prices of the investments within a particular fund but also by how popular a fund is among shareholders. For instance, with high-income investments commanding strong demand from income-hungry shareholders, closed-end funds that pay high distribution yields often trade at share prices that exceed the net asset value of the assets they hold. Again, because there's no mechanism to buy or sell shares at NAV as there is with a traditional mutual fund, discrepancies can last for a long time.
But when certain types of investments go out of favor, the closed-end funds that invest in them often trade at big discounts to their net asset value, essentially allowing investors to get bargains on the stocks they want. Consider some of the following closed-ends:
- Adams Express (NYSE: ADX ) is a $1.2 billion fund that owns a wide assortment of blue chip U.S. stocks, with a portfolio that includes many of the top names in the S&P 500. With an expense ratio of about 0.54%, it's somewhat more expensive than an index ETF but has traded at roughly a 15% discount on average over the past five years.
- Petroleum & Resources (NYSE: PEO ) is a $775 million closed-end fund managed by the same company as Adams Express but specializing solely in energy, mining, and other natural-resources plays. It has traded at a somewhat more modest discount ranging from 10% to 15% over the past year.
- Single-country closed-end funds targeting areas in beaten-down Europe have seen their discounts remain at high levels lately. Swiss Helvetia (NYSE: SWZ ) , New Ireland (NYSE: IRL ) , and New Germany (NYSE: GF ) all have discounts of 10% or more, focusing on their respective markets and trading largely in tandem with the benchmarks in those countries.
Dangers of closed-end funds
Some closed-ends have outrageous fees that sap too much of their return potential to be worth buying. But the biggest problem with closed-end funds is that many of them have low trading volumes of only a few thousand shares or less in a typical day, which puts even investors of modest means in a position where an abrupt purchase or sale can move the market. That makes them difficult to trade, and so if you invest in closed-ends, you have to be prepared to sit tight through occasional market disruptions that will lead to dramatic short-term price moves for closed-end funds.
The payback, though, is that closed-end funds go largely ignored by many big players in the market. As a result, by paying attention and jumping at value opportunities, you can boost your returns by taking advantage of temporary discounts, riding shares higher when those discounts disappear even if the fund's assets don't rise in price. That kind of advantage is too good for many small investors to pass up.
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