Closed End Mutual Funds
Closed End Mutual Funds are the original type of mutual fund, although today they’re not nearly as popular as their cousin. A closed end fund has a very different structure in that its shares are issued only at the inception of the fund and the amount does not change unless management goes back to the SEC for a reissue. Thus when you buy a share on the open market, you are not sending your money to the fund company the way you would with an open end fund. Instead, you are buying your shares from a shareholder who is selling in exactly the same way that you do when you are buying a stock or a bond.
This is an advantage to the manager because the amount of money that he has to allocate is not constantly changing each day based upon the whims of the market. He has the amount to invest that he has and the only way this changes is by his profit or loss in the market.
Because it trades like a stock, you can buy or sell at a particular price at any particular time of day in the market. However, because the fund represents a portfolio of assets which are themselves constantly changing in value, the shares of a closed end fund are usually at either a Discount or a Premium to the Net Asset Value of the fund.
This can mean that it’s possible for you to be correct in the direction of the underlying securities of the fund and still lose money as an investor in the fund. This could happen if the value of the holdings grew, but at a slower pace than that which the premium shrank between the time that you bought and sold the fund.
As an example, let’s say that you buy the fund XYZ for $110/share, but the underlying NAV of the fund is only $100/share. This means that you’re paying a 10% premium. If the value of the holdings increases so that the new NAV is $110, but the premium disappears and the fund is now selling for a discount of 10%, then you will only receive $99 when you sell your shares!
Of course this isn’t a likely scenario. Typically, the market exaggerates the returns of the underlying securities. Thus, if the market is falling, the value of the holdings will fall (and thus the NAV will fall), but because people are scares, the owners of the fund will also be selling at a faster clip than the general market is discounting the fund’s individual holdings. This is not a rule, but is what tends to happen.
What this means to you is that your fund might fall in value faster than the sector in which it is invested is falling. Of course the opposite is true as well. If a market is really screaming higher, your fund might start selling for a nice premium.
In this case, it would be possible for you to not only make money because of the increased value of your fund’s holdings, but also because the fund now carries a larger premium.
Let’s suppose that you know that you want to enter a market/sector, but you believe that it is currently overvalued &/or due for a correction. If you begin to study Closed End funds and find one that you like for the particular sector that you want to invest in, you should be able to find information about past premiums and discounts on the fund’s website. When the market correction comes, you might be able to buy the assets that you wanted to buy cheaper in the closed end fund world because often these funds will see large discounts.
If you are able to perfectly time things, you would buy the fund when the market is bottoming at a huge discount. You would later sell the fund when it is topping at a huge premium. Thus you earn the capital gains of the fund’s holdings PLUS you make another gain on the swing in price of the fund itself.
We’re sure that most investors end up achieving exactly the opposite of this however because most investors tend to buy in at the top and sell at the bottom. But if you have the discipline, understanding, and luck to buy and sell in this way, the swinging discounts/premiums of closed end funds can be a real advantage to you.
This is Part 4 in a series on professional money management and funds. You can find the prior posts by following these links: Pt 1, Pt 2, & Pt 3. We also recently began a series on asset allocation which in many ways relates to some of the purpose in funds, so you might want to check out the following posts: Pt 1, Pt 2, and Pt 3.