Closed-End Funds: Stocks on Sale!
August 27, 2010 | In: stocks
Most mutual funds fall into the “open-end” category. This means that a fund sells shares continuously, and there is no fixed number of shares available for purchase. Also, shares of open-end funds are not traded directly. The share price (or net asset value-NAV) is determined by the current market prices of the stocks in the fund’s portfolio, less any administrative costs. One purchases shares either from the fund itself or through a broker.
A relatively small number of funds is structured differently in that their share price is determined by the value of the underlying stocks AND the current trading price of the shares themselves. These are “closed-end” funds. They have a limited number of shares outstanding, and they trade like shares of individual corporations.
This means that at any given time, the NAV of a closed-end fund may be above or below its market price. As a result, your investment decision is more complex. Not only do you need to consider the fund’s portfolio, but you must also look at the market for the fund’s shares.
This fact presents some interesting scenarios. For example, you could purchase shares at a discount. That is, you pay less than the NAV of the fund’s stocks. Then you could sell the shares at a premium and receive more than the NAV. As a result, you have the potential to magnify any increase in the fund’s basic portfolio. The value of the stocks in the fund might increase 10% for example, but you might get a return of 15% because of the discount/premium phenomenon.
Let’s look at a few examples. (The data were obtained from the January, 1999 issue of Dow Jones Investment Advisor.) For the 12-month period ending Nov. 30, 1998, the top performing closed-end stock fund was the Spain Fund (SNF). The NAV increased nearly 53% while the market price rose about 50%. As of Nov. 30, the fund’s shares were trading at a discount of 14.8% to the NAV of $22.16. (Therefore, the market price was $18.88.) However, the top-performing stock fund based upon change in market price was the Growth Fund of Spain (GSP). Its share price rose 53.2% vs. a NAV change of only 42.7%. By the way, the Growth Fund of Spain also has the best 5-year record. Its average total market price return was 26.4%–easily ahead of the S&P 500 (23%) and Morgan Stanley’s EAFE Index (9.9%).
It is a bit of a mystery, but most closed-end funds typically trade at discounts. In other words, the market price is rarely equal to or greater than the NAV. On the one hand, this is an advantage: Why would you want to pay more for a share than its actual value? On the other hand, with such persistent discounts, an investor often needs to rely on very strong performance of the underlying portfolio.
So–should the closed-ends have a place in your portfolio? I personally prefer open-end funds, because their share prices are determined solely by the value of the stocks they own. Also, information about open-end funds is more readily available. Finally, you always need to pay a commission to buy a closed-end fund; “no-load” versions do not exist. If you do purchase a closed-end fund, I would suggest you monitor its performance more closely given the market price variable. You don’t get many chances to invest at a discount; unfortunately, those discounts never seem to go away!
Related posts: