The Mystery of Closed-End Fund Discounts

Investors are rational agents, economists like to say. In other words, for the most part, we're not nuts. If IBM trades at $190 a share, Uncle Hank isn't going to offer his lot at $150 -- and if he does, it's time to talk to Aunt Lily about handling the stocks.

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That assumption makes it difficult to explain the behavior of closed-end funds. It's not uncommon for one that holds, say, $13 a share worth of stocks or bonds to sell for $12. Discounts like that give investors an opportunity to secure dividend yields that are larger than the yields on the underlying stocks and bonds. And if they choose wisely, they can make money two ways, says Doug Bonds, manager of the Cohen & Steers Closed-End Opportunity fund: (1) when the fund assets earn a return, and (2) if the fund discount shrinks.

For long-term savers, closed-end funds aren't nearly as attractive as high-quality stocks or low-cost index mutual funds. That's because many closed-end funds charge high fees and some use leverage. For traders with an appetite for risk, however, it's worth considering the basics of how closed-end funds work and whether discounts can be exploited for profit. Most investors are familiar with open-end mutual funds (think Fidelity Magellan). They're priced at the end of each trading day according to the value of underlying investments -- no discounts or premiums. Exchange-traded funds have share prices that can differ from the value of their assets, but in practice, most only differ by a whisker. That's because each ETF has "authorized participants" who are empowered to convert shares into the underlying securities, and vice versa. They continuously trade away discounts and premiums for their own profit. Closed-end funds trade just like ETFs, only without the authorized participants, so there's no one to keep the prices near the asset values. According to research by Scott Barnhart, a professor at Florida Atlantic University, ETFs have lured investors from closed-end funds. That might have resulted in bigger discounts for the latter.

So neglected have closed-end funds become that one New York University professor, Edwin Elton, last year wrote a paper titled "Why Do Closed-End Funds Exist?" One supposed advantage is that closed-end funds usually issue shares only once, during an initial offering period. After that they close -- hence the name -- and list the portfolio on an exchange. Shareholders who sell don't affect the portfolio assets; they simply sell shares to buyers. That should allow closed-end fund managers to buy less-liquid securities without fear of having to suddenly raise cash. But in practice, most closed-end funds hold the same sorts of things as open-end ones, according to Elton. He reckons the existence of closed-end funds is owed mostly to their effective use of leverage. Open-end funds face strict limits on leverage. Closed-end ones have long borrowed cheaply (with low interest rates) and invested in long-term bonds with higher yields. But cut-rate funding dried up during the 2008 financial crisis, forcing closed-end funds to pay more for fresh cash, so leverage today isn't quite as lucrative, says Elton.

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Buyers want to look for closed-end funds with high yields --but not too high.

Fund (Ticker)	Key Assets	Share Price ($)	Dividend Yield (%)	Discount (%)	Expense Ratio*	3-Year Total Returns, Annualized (%)
BlackRock Strategic Dividend Achievers (BDT)	U.S. dividend stocks	10	6.6	13.3	0.93	15.6
Calamos Global Dynamic Income (CHW)	Global stocks and bonds	8	8	15.6	1.52	28.7
Eaton Vance Tax-Advantaged Global Div. Opp. (ETO)	Global dividend stocks	17	8.1	14.9	1.1	21
First Trust Enhanced Equity Income (FFA)	Stocks and covered calls	11	8.1	13.2	1.25	21.3
John Hancock Bank & Thrift Opportunity (BTO)	Financial stocks	14	6.4	12.3	1.34	3.9
Kayne Anderson Midstream Energy (KMF)	Master limited partnerships	23	5.2	13.3	1.9	NA

Data as of 12/7/11. * Excludes interest. NA=Not applicable. sources: bloomberg; CEFConnect; company filings

Still, closed-end fund discounts are tempting. They're also one of the unsolved mysteries of finance. There are several theories on why they exist: Some researchers think they're a judgment on fees and performance; some think investors use discounts to anticipate money that will be lost to taxes on embedded gains. One recent study showed a link between discounts and investor expectations about broad market volatility, suggesting discounts grow larger simply because investors are worried.

Whatever the cause, investors might be able to profit from closed-end fund discounts. One reason: They tend to be mean-reverting. Find one that's larger than its historical average and there's a good chance it will shrink, says Cohen & Steers's Bonds. Another reason is the presence of activist shareholders. In the stock world, these investors like to scoop up 5 percent or more of the shares of troubled firms and then use their clout to badger management to sell assets, cut costs and take other steps to lift the stock price. In the closed-end world, activists have increasingly persuaded funds to convert to open-end structures. When that happens, discounts disappear.

Closed-end funds can be volatile because of their leverage, and their discounts work both ways; they sometimes grow larger, too. That makes these funds best for nimble investors. Also, an investor who spots a fund at a 10 percent discount shouldn't assume it's a good deal, says Mike Taggart, a closed-end fund strategist for Morningstar; the fund might historically have traded at an average discount of 12 percent. Morningstar evaluates closed-end funds in part by comparing their current discounts with their past discounts. The six funds listed turned up in a recent screen for discounts that are larger than they typically have been in the past.

Investors should be aware of an accounting quirk that can affect fee comparisons on closed-end funds that use leverage. By law, they must report their interest costs as part of their expense ratios even if they put their leverage to profitable use. That can make these funds appear more expensive than they are. Expense ratios listed exclude borrowing costs.

For diversified exposure, Bonds's fund holds 184 other closed-end funds, which in turn invest in stocks, bonds and other assets. Over the past three years, the fund has returned 10.9 percent a year, compared with 1.2 percent for the S&P 500 and 8.0 percent for the Barclays Capital U.S. Aggregate Bond index. It recently traded at a 9.6 percent discount to the prices of the funds it holds, with a dividend yield of over 9 percent.

A high yield on a closed-end fund is a key shareholder advantage, says Elton. As long as the discounts don't increase, investors can do better than they would on the underlying stocks and bonds. But be cautious about a yield that looks unrealistically high, says Taggart. It could be a sign that the fund is paying more than it's making on its underlying assets. That's a recipe for a gradually slipping share price.