Published January 13, 2017
An area of the investment universe that receives little attention these days is the closed-end fund. These funds seem to have fallen somewhat out of favor among individual “retail” investors as exchange-traded funds (ETFs) have exploded in popularity over the past decade. They are a niche investment product to be sure, but one that can offer unique and sometimes compelling opportunities.
A fund is “closed-end” because it has a fixed number of shares outstanding. Thus, if someone wants to buy a share in the fund, someone else needs to be willing to sell. To achieve that market matchmaking, price fluctuates until a buyer or seller is found. This market mechanism makes closed-end fund pricing typically more volatile than open-end funds, depending on the volume of trading activity in a particular fund. The other result of this market mechanism is that the fund’s traded price can, and usually does, vary from the value of the fund’s underlying investments – referred to as the fund’s Net Asset Value (NAV). The difference between the traded price of the fund and the value of its underlying assets is referred to as the fund’s premium or discount to NAV. As shown here, that discount can become alarmingly big:
chart 1 – Closed-end funds often trade at a discount to the value of their investments
chart 2 – And that discount can become quite large
Open-end funds, like ETFs and mutual funds, are able to create and retire shares in order to keep their price and NAV roughly in sync. You do find premiums and discounts to NAVs in the ETF world, most commonly among bond ETFs where it’s difficult to adjust the portfolio of bonds quickly. But they are usually <2% compared to the 10% that often occurs in closed-end funds.
Another factor making closed-end fund pricing (and Net Asset Value) volatile is that they are typically leveraged investment vehicles, often carrying a +30% leverage. This means that the fund borrows an additional 30% of the fund’s value to buy more assets. Chart 3 shows the closed-end fund (in red) against an open-end ETF version (in blue). You see the higher volatility and swing in the price of the red line.
chart 3 – Closed-end fund price is more volatile than with ETFs
However, the leverage also allows the closed-end fund to pay a higher yield. The unique opportunity arises when the discounts get unusually large. This typically occurs when an asset group sells off. In the closed-end fund, you will not only benefit from a recovery in the market for that asset, whenever it comes, but also from a narrowing of the price discount as the asset gets out of the doghouse.
In summary, closed-end funds offer higher yields and the potential for greater price appreciation than their open-end ETF or mutual fund siblings but at a cost of much higher volatility. If you watch their prices regularly, however, you can find some very compelling bargains. Go look at closed-end funds when an asset group gets out of favor if you want to really juice your portfolio.
Once again, the wonder that is Amazon
We have written a number of times about the stock of the Amazon Corporation. It routinely trades at a price well ahead of its earnings; and, as a result, would never be considered a “value” stock. But it also routinely grows into that elevated price. Since 2006, a timeframe that includes a broad stock market bust and recovery, Amazon stock has taken over the retail world. Chart 4 shows just how dominating that performance has been from a stock market value perspective. Total market value of all other major retailers remains below their 2006 level. Amazon, by stark contrast, is almost 20x higher. This has positioned Amazon to be worth more than almost all of its competition COMBINED. Capitalism relies on competition to create innovation. When one company becomes markedly better (e.g. “wins” the competition) the spoils flow in exceptional size to the winner. So it is with the one-time online bookstore who now dominates almost all of retail and seeks to also become your grocery store over the next few years. The cultural and economic impacts of this massive shift are truly historic.
chart 4 – The overwhelming dominance of Amazon
Stocks opened the week in quiet trade with concerns over OPEC’s ability to stick to supply constraints pushing oil prices down. Defensive sectors were also weak despite a continued retreat in interest rates. The broad market closed off -0.3%. Tuesday offered the same story with another flat finish. It should be noted that both Monday and Tuesday saw the Nasdaq continue its 2017 outperformance with +0.4% ticks higher each day. Healthcare took some blows Wednesday on President-elect Trump’s comments regarding drug prices.
However, tech stocks continued to perform well helping the broad market finish positive by +0.2%. Stocks encountered their first real selling pressure of the new year Thursday with some analysts giving credit for the weakness to Mr. Trump’s lack of mention about any economic stimulus plans in his Wednesday press conference. Nevertheless, after being down about -1% early in the day, stocks found buyers to recover to a -0.2% close. Friday brought a narrow session with big banks reporting earnings before the open. After their +20% run-up in the final quarter of 2016, it was worthwhile to see how investors would respond to the earnings – e.g. whether they would ‘sell the news’ or not. The answer, at least for the day of earnings, was that investors were fine continuing to own bank stocks. Earnings came in roughly as expected for the three big ‘money-center’ banks: JP Morgan (Chase), Bank of America, and Wells Fargo. The broad market held to a +0.2% lift while the Nasdaq once again outperformed.
Warm wishes and until next week.