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How to Pick
Closed-End Funds
Last year, the Latin American Discovery Fund, an investor in Latin
American stocks and bonds, generated a 46% return for its investors,
including $5.12 per share paid in dividends. But 2007 wasn’t unusual. The
fund has averaged a 56% annual return over the past three years.
Latin American Discovery is a special type of mutual fund called a
“closed-end” fund. Let me explain.
Open vs. Closed
Conventional mutual funds are termed “open-end” funds. When you buy
an open-end fund, you are purchasing shares from the fund itself, even if
you buy through a broker, The price you pay is the net asset value (NAV),
which is the value of the fund’s holdings (assets), expressed on a
per-share basis. The fund’s share price depends solely on its NAV, not on
how many investors want to buy or sell its shares.
By contrast, a closed-end fund sells a fixed number of shares when it
starts business via an initial public offering (IPO). After that, the fund
doesn't buy or sell its shares. New buyers must purchase from existing
shareholders, and shareholders must find a buyer when they sell.
Closed-end fund shares trade like stocks at prices reflecting the balance
between supply and demand for the fund’s shares. They rarely trade at the
net asset value.
Unlike their open-end fund counterparts, closed-end fund managers have a
fixed amount of money to invest. They can implement long-term strategies
without worrying about raising cash to redeem shares, or finding places to
invest unexpected new cash.
This stability seems to lend itself particularly well to funds that focus
on paying high dividends to shareholders. In fact, many investors buy
closed-end funds strictly for the income.
About Closed-End Funds
Closed-end funds usually specialize in a specific investment
category such as municipal bonds, corporate or government bonds, or in
stocks.
The Closed-End Fund Association (CEFA), the industry trade group (www.cefa.com),
is the best resource for learning about closed-end funds as well as for
finding funds of interest.
Start your research by downloading the booklet
Closed-End Funds 101 from CEFA’s homepage. It’s only five pages
long and includes information you need to know before investing.
Finding Funds
You can use CEFA’s Fund Selector to build a list of fund candidates
based on historical returns for timeframes ranging from one-day to
five-years. The Fund Selector also allows screening based on two fund
properties that may be unfamiliar to you: premium/discount and leverage.
Here’s how to interpret them.
Premium/Discount
As mentioned earlier, closed-end funds rarely trade at their net asset
value. Shares are said to be trading at a premium when changing hands
above their NAV, and at a discount when below. Most trade at a discount,
but, in-demand funds, those in a popular category, trade at premiums. All
else equal, a fund trading at a discount should yield higher returns than
a similar fund trading at a premium.
Every fund’s discount or premium varies with market conditions. So, give
preference to funds trading at higher than usual discounts (or smaller
than usual premiums). You’ll enjoy the extra capital appreciation when the
fund reverts to its usual range. You can use ETF Connect (www.etfconnect.com)
to see a fund’s premium/discount history. From the fund’s
Quick Facts page, click on “Since Inception” in the Premium/Discount
History section to view the complete history.
Leverage
Many closed-end funds employ leverage, meaning that they borrow to
increase their returns. For example, they may borrow at
4% and invest those funds in assets returning 9%.
In that example, the fund is making 5% on its
borrowed funds. Typically, leveraging helps returns when interest rates
drop, or when the spread between short- and long-term rates (yield curve)
is widening. Both of those conditions are happening now. However,
leveraged funds suffer when interest rates rise or the yield curve
narrows.
You can use the Fund Selector to search for any fund type or limit the
field to categories as narrow as California Insured Municipal Debt Funds.
I selected Latin American Funds within the Global/International Equity
category.
You can search either using market returns or net asset value (NAV)
returns over your specified timeframe. The market return is what you would
have actually realized had you owned the fund. However, because the
premium/discount varies over time, the NAV return is a better measure of
the fund’s fundamental performance. Both returns are annualized and
include dividends received.
I searched based on three-year NAV return. You can limit your search to
funds trading at a premium or discount, and you can exclude leveraged
funds. You can also select a maximum allowable expense ratio, which is how
much of a fund’s assets go to operating expenses. I left all three of
those parameters unselected.
Six Funds Found
My screen turned up six funds including the Latin American
Discovery Fund (ticker symbol LDF) that I mentioned earlier. According to
CEFA, that fund’s NAV return averaged 47% annually over the three years
ending December 31, 2007. The other funds were Latin American Equity (LAQ)
returning 46%, Mexico Equity & Income (MXE) with a 41% return, Mexico Fund
(MXF) returning 34%, Chile Fund (CH), averaging a 24% return, and finally,
Herzfeld Caribbean Basin (CUBA), with a 16% average annual NAV return.
You can click on the fund name in the screen results to display
considerable information about each fund, including its biggest holdings.
But the aforementioned ETF Connect, and Morningstar (www.morningstar.com),
both offer more complete data.
There’s a saying in the stock market that “trees don’t grow to the sky.”
There is no guarantee that the Latin American funds that I found will
repeat their mind boggling historical returns. Nevertheless, closed-end
funds offer intriguing opportunities that most investors overlook.
published 1/6/08 |
