While many investors may have a basic understanding of closed-end funds (CEFs), there are some important characteristics which should be understood in-depth by all investors. Closed-end funds are typically much less transparent than their open-end counterparts, but with our short tutorial you will be able to quickly analyze the merits of a closed-end fund and find profitable investing opportunities. Three distinct features of CEFs that we will examine are premium/discounts, private portfolio holdings, leverage.
Since the price of a CEF is determined by supply and demand they will often trade at either a premium or discount relative to the true underlying value of its portfolio. In most cases, it will never make sense to buy a CEF that is trading at a meaningful premium; however, the flipside means that funds also trade at a meaningful discount, which can provide a great investment opportunity for the astute investor. If a portfolio is worth $20 per share, then paying $18 per share is a great deal. While funds that trade at discounts of 5-20% may be a good deal, funds which trade at 25-50% discounts may actually be a poor deal. Before buying a fund purely on the size of the discount, ask yourself why the discount is so big. While a 5-15% discount may not be deserved and should be corrected over time (the stock price rising to its true value), a sustained discount of 30% could imply very poor management, very high fees, or some other desirable feature that is making people avoid the fund.
Private Portfolio Holdings
One of the unique aspects of CEFs is that they have the ability to invest in a wide range of assets, including making venture capital investments in private companies. For example, the $150 million Harris & Harris Group (TINY) fund invests in preferred stock of early-stage companies, seeking large capital gains if the companies become successful. This type of investment is not typically available to the average investor, and the portfolio holdings can sometimes help explain the premium/discount discussed above.
Another unique aspect of CEFs is that they are allowed to use extensive leverage in managing the fund. The Denali Fund (DNY), for example, is over 30% leveraged through taking on debt and preferred shares. This strategy of attempting to increase capital gains and income through leverage is very common in the CEF industry—approximately two-thirds to three-fourths of all CEFs use leverage either through debt borrowing or issuing preferred shares. Most of the leveraged CEFs are municipal bond funds trying to get a higher yield by investing in more bonds than they otherwise could. One final note: be wary of any fund with too much debt—if we have learned anything from the recent financial crisis, it is that debt may pump up returns in the short term, but too much debt significantly increases the risk of a crash.
Closed-end funds are unique in their structure, holdings, and use of leverage. By finding discounted CEFs and understanding the fund’s use of leverage, you can take advantage of these investment opportunities and have an edge over the average investor.