Talk about money: Bargain hunt for closed-end funds at the end of the year

Closed-end funds are not to be confused with their younger and more popular cousin, the exchange-traded fund.
Both are investments that trade like stocks on major exchanges. Both issue shares that represent ownership of a basket of stocks or bonds. But unlike ETFs, closed-end funds sometimes give investors the chance to buy a dollar’s worth of stocks or bonds for 90 cents or less — especially near the end of the year.
Thomas Herzfeld, a money manager in Miami who specializes in closed-end funds, says “this is a very fertile year for bargain hunters.”
To explain how these funds can fall to bargain prices, I need to define the term “net asset value.” Let’s say a fund owns a basket of securities that are worth $100 million, and there are 10 million shares. Then, each share has a net asset value of $10.
If the fund is an ETF, the shares will sell on the stock exchange within a few pennies of $10 a share. But if the fund is a closed-end fund, the per-share price is completely determined by demand for the shares. If buyers and sellers are impressed with the managers of the fund, they might be willing to pay $11 a share for $10 worth of assets. If they aren’t impressed with the managers, they may be willing to pay only $9 a share for $10 worth of assets.
It’s that divergence from net asset value that creates the kind of buying opportunity Herzfeld sees now.
Herzfeld said some closed-end funds that invest in municipal bonds have declined in price recently, because of fears that state and local governments might not be able to make their payments. When shares of a closed-end fund have a bad year, many investors sell the shares in December to lock in losses for tax purposes.
That double-whammy is pushing prices of some funds down to bargain levels, Herzfeld says. Those are what he’s buying, with the expectation that the fund’s share price will rise closer to its net asset value next year, after the tax-loss selling is over.
To illustrate Herzfeld’s strategy, let’s return to the above example. Say there are two portfolios of stocks, an ETF and a closed-end fund, both with net asset values of $10. The ETF sells for $10, but for some reason, the closed-end fund sells at a 10 percent discount, at a price of $9.
If the stock market goes up by 10 percent and the two funds match that growth, then the ETF will rally to $11 a share. The closed-end fund’s net asset value will also rise to $11 a share, but its price could rise by more than that, as the discount to net asset value shrinks.
“If you own an ETF, you make whatever the market does,” Herzfeld said. “I’ve been trading closed-end funds for 42 years and have consistently been in the top 10 percent of money managers. I never could have achieved that with ETFs.”
There’s no guarantee a closed-end fund selling at a discount will ever see its price return to net asset value. Part of Herzfeld’s strategy is to look at how much of a discount or premium to net asset value a fund’s shares have traded at historically. If a fund has sold at a 5 percent discount on average over the years and Herzfeld sees a chance to buy it at a 10 percent discount, he buys, expecting the shares to return to their average 5 percent discount, enabling him to sell at a profit.
There are a number of ways for investors to find information on closed-end funds, including Morningstar’s Web site, www.morningstar.com, and the Market Week section of Barron’s financial weekly, which can be read at local libraries.
Mark Rosenberg is an investment consultant for Financial West Group in Scotts Valley, a member of FINRA and SIPC. He can be reached at 439-9910 or [email protected].