Successful long term investors make money because they do two things. They pick investments that are likely to provide a healthy return and they wait to buy until that investment is selling at a discount to its long term value. This is the concept of intrinsic value that we have so often discussed. An investment that may be attractive today is a closed end fund because the volatile market is making many closed end funds cheaper.
What Is a Closed End Fund?
Investopedia explains closed end funds.
A closed-end fund is organized as a publicly traded investment company by the Securities and Exchange Commission (SEC). Like a mutual fund, a closed-end fund is a pooled investment fund with a manager overseeing the portfolio; it raises a fixed amount of capital through an initial public offering (IPO). The fund is then structured, listed and traded like a stock on a stock exchange.
A problem with closed end funds is that they often sell at a price in excess of their net asset value.
One of the unique features of a closed-end fund is how it is priced. The net asset value (NAV) of the fund is calculated regularly. However, the price that it trades for on the exchange is determined entirely by supply and demand. This can lead to a closed-end fund trading at a premium of a discount to its NAV.
Funds can trade at premiums and discounts for a number of reasons. Closed-end funds focused on a popular sector at the time may trade at a premium. These funds may also trade at a premium if the fund is managed by a historically successful stock picker.
Conversely, a lack of investor demand or a poor risk and return profile of the fund can lead to it trading at a discount to its NAV.
In this regard Forbes writes about how to buy your favorite stocks at a discount.
One of the greatest things about closed-end funds (CEFs) is that they often cost less than they’re really worth.
Even after the recent volatility, these funds are up around 15% from a year ago. The best news is that there are still a lot of discounted CEFs floating around.
The point is that in the current volatile market many closed end funds are selling at less than their net asset value. This is an intrinsic value investor’s dream come true. But, knowing when to buy and when to avoid closed end funds is important.
Pros and Cons
US News writes about the pros and cons of closed end funds.
A closed-end fund produces a finite number of shares at the start. After the initial public offering, shares are traded on the stock market with prices rising and falling with investors’ views about the assets in the fund and the fund manager’s skill. CEFs are sometimes described as ancestors to exchange-traded funds, but CEFs have a fixed number of shares while ETFs can raise or lower the figure as demand changes.
That means the CEF share price is set by supply and demand, adding a layer of risk and opportunity.
“The price of the fund can vary far from the fund’s net asset value,” Vogel says. “Since the fund is closed, no new shares are created when an investor purchases them, allowing the price the ability to float to a premium or discount to the fund’s NAV.”
Supply and demand control prices of closed end funds. But the supply in a closed end fund is unchanging and so when the fund is popular it tends to be overpriced. And when investors get cold feet in a volatile market a closed end fund is often underpriced as is the case today. Investors in closed end funds need to keep track of the net asset value of the fund and invest only when the fund in underpriced in regard to its current and projected future value.