HowtoInvestOnline: Closed-End Funds

Monday 22 December 2008

Closed-End Funds - Opportunity vs Risk

A Closed-End Fund (CEF) is an intriguing beast that currently offers potentially highly attractive investment returns but, as usual, there are risks.

The CEF is similar to the mutual fund and the exchange traded fund (ETF), as seen in the following table.

What makes the CEF intriguing is that unlike both mutual funds and ETFs, a CEF's market price may vary considerably from the sum of the values of the securities held by the fund, called the Net Asset Value (NAV). Most commonly the CEF's market price is lower by 2-6% than the NAV, which is termed trading at a discount. Sometimes, however, there is a premium.

The following partial list from GlobeFund's Closed-End Fund report, sorted by discount/premium, shows that the divergence at the moment is extreme with many enormous discounts.

More than half of 225 Canadian CEFs are currently trading at over 10% discount. NAV is supposed to represent the true value of the fund holdings and CEFs are obliged to report changes as often as the market price of their holdings change. Buying a heavily discounted CEF is an opportunity to buy a bargain. The "% off" sale may now be at a peak.

Why the steep discounts and is the opportunity real? The answer arises from the risks of CEFs:

Illiquidity - CEFs trade in lower volumes and may be harder to sell quickly, especially so with smaller funds; this is considered to be a permanent reason for a small discount
Leverage - some funds use leverage or borrowing to enhance returns, which works fine in good times but punishes in bad times; the credit crunch combined with leverage is what appears to be the undoing of Bayshore Floating Rate Senior Loan Fund (TSX: BIF.UN) first on the list at a 92% discount and about to be wound up
Credit Quality - fixed income CEFs may suffer when worries about credit quality of holdings increase, even if the official ratings stay the same
Equity Concentration - a CEF with a high concentration of shares in a sector or a particular company will have higher volatility. Perhaps this is what is affecting (66% discount to NAV) First Asset PowerGen Fund (TSX: PGT.UN), which has around half its assets invested in a private company developing wind farms and other renewable power generation
Market Sentiment - since a CEF's price is market-determined separately from the NAV, the CEF as a vehicle may fall out of favour independent of its holdings; many CEFs do not have redemption privileges or repurchase schemes that keep price in line with NAV, unlike ETFs; the "flight to safety" of the current financial crisis may be especially harming CEFs. If fear is driving higher discounts, in some cases there may be true long term bargains amongst CEFs.

What I think CEFs are best suited for:

bargain hunting, where the discount is large and where the NAV appears to be solid after due diligence research into the CEF and its holdings
specialized sectors such as high yield bonds, US municipal bonds, emerging market equity and debt, small cap companies, where a fund is desired but low-cost ETFs or mutual funds are not available; some asset classes where CEFs are more numerous and successful -
a long term investment to produce regular income at a higher return (from the discounted NAV)

Where to Find:
Listings & CEF Company Links