You have to admire closed-end funds. Unlike traditional mutual funds where purchases and redemptions at the end of the trading day shape the number of fund shares outstanding, closed-end funds trade publicly. You want in? Buy your shares from someone who wants to cash out.
Yet because the stock price fluctuates, it will never be a perfect match to the value of its basket of stocks. More importantly, unlike conventional open-end funds, some closed-end funds can be bought at significant discounts to their net asset values (NAV).
Back in April, just after the successful launch of Motley Fool Champion Funds, I wrote about Tri-Continental (NYSE:TY) in 85 Cents for a Dollar?. Today I can refer to the company as just 83 cents for a dollar, as the stock closed at $17.75 last night while the market value of its stock holdings divided by the number of shares outstanding is $21.26. So, yes, you can buy the fund at a 17% discount. The fund's been around since 1929, and along with its low expense ratio of 0.7% and blue chip portfolio that includes companies such as Citigroup (NYSE:C), Microsoft (NASDAQ:MSFT), and Altria (NYSE:MO), you could certainly do far worse in the market these days.
Yet there is also a flip side to the discounts, and that is closed-end funds that trade at a premium. Whether it's an aggressive income fund, bid up by naive investors who don't understand that high yield entails high risk, or simply an exotic equity fund that is in demand, I'll never understand why folks pay a premium for a fund -- yet they do.
That's why you should always be blinking amber when you see a new closed-end fund set to go public. Because the fund will have underwriter fees to pay for lending a hand with the IPO, the new fund will have less money to invest. That means that it will have a 10% to 15% premium attached to it even at the offering price.
So when Pioneer announced that it was launching a new closed-end income fund that will invest in senior floating rate loans, I was skeptical. No, I have no problem with the strategy. We are in an environment in which rates are likely to rise, so floating rate loans are attractive. My concern is that investors are going to buy in and either expect a pop from the $20 offer price or not realize that some of that pocket change will go to pay the underwriters, dropping the fund's initial NAV.
To be sure, I went ahead and pulled up the market price and NAV of the five existing Pioneer funds. Four of them traded at discounts, with Pioneer Interest Shares (NYSE:MUO) and Pioneer Tax Advantaged Balanced Trust (NYSE:PBF) fetching double-digit discounts to their NAVs. That's not a knock on the funds or Pioneer. Actually, if I were an income investor I may find those discounts tempting. However, that's also why one should avoid new closed-end offerings.
Give them some time to settle and sink to realistic valuations if you want. With so many closed-end funds trading at a discount and no-load funds trading at market value, you deserve better than paying for more than you are getting.
Do you prefer open-end funds to closed-end ones? Is the fact that shares of the closed-end funds trade actively throughout the day a positive or a negative? Have you checked out our Motley Fool Champion Funds newsletter? All this and more -- in the Mutual Funds discussion board. Only on Fool.com.
Longtime Fool contributor Rick Munarriz does not own shares in any company mentioned in this story. He is a member of the Rule Breakers analytical team, seeking out tomorrow's great growth stocks today.
