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Exotic Investing: Closed End Funds

July 21st, 2009 by 
PK

Oftentimes the best place to look for value is in a place few others know to look.  That's certainly the deal for closed end funds... a massively underused and unexplored asset class for most investors.

Go ahead and quote that; I just made it up. Closed end funds are an often overlooked place in the market for your investment funds.  CEFs are mutual funds which trade on exchanges and lack the price arbitrage functions of Exchange Traded Funds.  This means that Closed End Funds can be (and often are) priced significantly differently from their underlying assets.

What are Closed End Funds?

Closed end funds are like an unopened treasure chest!

What Is a CEF? Let's Open them Up!

Closed end funds generally offer shares  in the form of an Initial Public Offering or Secondary Offering.  These shares cannot be redeemed for the underlying assets; this is what I mean when I say that the shares have no inbuilt arbitraging function (unlike ETFs which allow exchanges which allow investors to benefit from any deviance from the underlying assets).  One of the great unsolved mysteries of Closed End Funds is why they are so often priced at a discount to their net asset value (NAV).

Closed end funds exist for all sorts of assets.  They are free to employ more exotic strategies than most funds... CEFs exist which offer leverage, invest directly into Mortgage Backed Securities, and many illiquid assets which are generally untouchable by normal funds.  In order to assist with price discovery, two prices are quoted:

  1. Share Price - The market price of the security
  2. Net Asset Value - The market value of the underlying securities in the fund.

No Risk?  No Reward.

Closed end funds seem to be a good arbitrage opportunity.  By shorting the underlying assets in a discounted fund and buying the fund itself, you would be rewarded when the spread between the market price and NAV narrowed.  For whatever reason, CEFs tend to keep their premium or discount for long periods of time.  Many CEFs started trading in one direction and have continued to this day.  The thinly traded nature of the products allow you to find overlooked funds but you also may be punished by ETF quirks.  Discounts can increase; during the market's recent plunge, CEF discounts moved to very high values.  CEFs have very unique risk factors you need to consider when doing your due diligence.

Talk it over with your investment advisor and see if there's a place in your portfolio for some CEF goodness.  They are especially useful for generating income... CEFs tend to have very large distributions compared to market average dividends.  Get started researching today... ETFConnect and the Closed End Fund Association are great resources.  For information on individual CEFs, I like to read through the Yahoo! Message Board or consult the forum at Morningstar.  Seriously- take a look at this secretive corner of the market.  You may find exactly what you're looking for...

Disclaimer! Make your own investment decisions.  Anything mentioned should only be used as a starting point.  Caveat emptor, and carpe diem.

Don't Quit Your Day Job...

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