This article was updated on Jan. 26, 2018.
Smart value investors look for $0.50 deals on dollar bills. Historically, they've gotten some good deals like that on closed-end funds. But with those value propositions evaporating and even turning into expensive disasters waiting to happen, more investors are shying away from the closed-end space.
According to the Investment Company Institute, closed-end funds haven't participated in the general rise in fund assets that has pushed exchange-traded funds above the $3 trillion mark. At $275 billion, closed-end assets are still well below their peak levels in 2007, and new closed-end fund issuance has come to a virtual standstill. Closed-ends issued just $3.5 billion in new shares in 2016, or just over a tenth of what they issued at their peak.
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What's a closed-end fund?
Back when the traditional mutual fund industry was much smaller and before ETFs even existed, closed-end funds gave investors many of the advantages that ETFs now provide. Unlike regular mutual funds that are open for trade only once a day, closed-ends trade on stock exchanges, making them available to buy or sell anytime the market is open.
One thing that makes closed-ends interesting, though, is the fact that they often trade at a significantly different price from the net value of their assets. Sometimes, share buyers can score some big discounts compared with what the fund's underlying investments are worth. That can provide some bargain opportunities for patient investors who are willing to wait for those discounts to narrow.
A disappearing opportunity
But closed-ends have faced some headwinds lately. On one hand, enough investors have become familiar with the funds that their discounts have narrowed substantially. One analyst says that with many closed-ends selling at discounts of 20% or more during the financial crisis, the average discount now is closer to 3%. That narrow discount simply isn't a big enough bargain to justify the higher costs that many closed-ends impose.
At the same time, ETFs have increasingly encroached on territory once dominated by closed-end funds. For instance, with dividends playing an ever-increasing role in their return expectations, income-generating vehicles like master limited partnerships were popular targets for closed-end funds. Yet the rise of income-oriented ETFs has largely shut out closed-ends in many of those areas.
Danger ahead
Some previously hot closed-ends have cooled off lately, hurting investors. For instance, the Central Fund of Canada (CEF 1.53%), which holds gold and silver bullion, had seen consistent premiums to net asset value during the precious metals boom. But now, it trades at a slight discount, and that has exacerbated long-term declines and produced worse returns than simply holding bullion would have generated.
Yet even those recent drops haven't reined in other high-flying closed-ends. There are still some funds with extremely high premiums, setting the stage for underperformance in the future when those premiums narrow.
Be careful
Closed-ends always have one sure winner: the management companies that run them. From Franklin Templeton (BEN +1.01%) and its well-known international offerings to BlackRock's (BLK +0.00%) huge stable of equity and bond closed-ends, the fact that investors can't redeem shares directly with fund companies ensures a locked asset base from which to collect management fees. In an era where investors move in and out of funds at a moment's notice, that kind of certainty is extremely valuable.
Closed-end funds still have uses, and you can still find good deals if you look hard enough. But if you just jump into a fund without understanding the fundamentals of closed-ends, you can easily get burned.
