NEW YORK (CNN/Money) - There's good money to be made in closed-end funds -- you just have to catch them at the right moment.
To understand why closed-ends sometimes offer the chance for market-beating gains, you need to consider the unusual way they function.
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Closed-end funds were popular in the 1920s and were the forerunners of today's mutual funds. Like modern open-end funds, closed-ends hold diversified portfolios of securities and usually distribute income and capital gains each year.
They differ from open-end funds in a couple of key ways. The most important is that their size is fairly constant. Unlike open-end funds, which sell new shares or redeem them as investors add or withdraw money, closed-ends generally have a fixed number of shares outstanding. That means you usually have to buy shares from other investors.
As a result, the share price of a closed-end is determined largely by investor demand, and shares can (and usually do) trade at a discount or a premium to the net asset value of securities in the portfolio. (Open-end funds are normally valued at NAV.)
Closed-ends typically trade anywhere from a 16 percent discount to a 2 percent premium. As a rule of thumb, discounts of more than 10 percent suggest that a fund may be undervalued -- and a discount close to 15 percent may be highly attractive.
Such large discounts offer the opportunity for a profitable double play. If you buy a fund with a successful portfolio, you will benefit from its increasing NAV. And if the fund becomes popular, the discount will shrink -- and the market price of your fund will move up even faster than the NAV.
Because these unique securities held up better than the average stock during the recession, and bounced back faster after the recovery began, discounts are much smaller than they were five years ago. But if the recovery stalls, discounts could increase again -- and that would likely be a great buying opportunity.
Often, closed-ends specialize in particular securities, a specific industry, for example, or stocks of a single foreign country. Ideally, you want one that focuses on an area capable of strong growth.
You should also examine the fund's expenses and its track record. Closed-ends often have high costs, so look for an expense ratio below those of competitors. And avoid funds that have greatly underperformed their peers.
The most important factor, though, is the size of the discount. And be sure to compare it with the fund's historical levels. A 14 percent discount isn't necessarily cheap if a fund has always carried a 14 percent discount -- but it might be compelling if the fund used to trade at less than 9 percent.
To get detailed information on closed-ends, you'll have to consult specialized research. Standard sources, such as the Value Line Investment Survey and Morningstar, cover selected closed-ends. The largest full-service brokers also provide proprietary research.