Some see buying opportunity in closed-end funds

As a lot of investors headed for the hills during the burst of stock market volatility over the past few weeks, some corners of the closed-end-fund space have emerged as value plays. Most closed-end-fund categories have seen share-price discounts widen in October compared with the 2014 average, but some, including growth, loan participation and bond funds, have seen the discounts widen by at least 2 percentage points in the past three weeks. According to Lipper Inc., the average growth fund category discount for October is at 13.1%, compared with 7.8% since the start of the year. The loan participation fund average discount is up to 9.1%, from a 6.5% 2014 average. And the average discount for general bond funds is up to 5.9%, from 3.8%. Across all categories, the average discount has been hovering above 8% since Oct. 10, which compares with an average discount of 5.9% at the end of May. While the closely watched discounts to net asset values can swing wildly in the closed-end funds universe, it sometimes takes time for things to get back into balance, thus creating some short-term buying opportunities. “Whenever there's market decay, the best place to put capital to work is in closed-end funds,” said Joseph Clark, managing partner at Financial Enhancement Group. “I have been putting more money to work, because when fear sets in, rationality goes out the door,” he added. “Our job, as financial advisers, is to be risk averse and to look for disproportion in the markets, and whenever indiscriminant selling starts, it will show up most in closed-end funds. That's why you should have a list of babies you want to buy if they happen to get sold — or thrown out with the bath water. Valuations fluctuate across all investment and asset classes, but closed-end funds are unique in that the price is set apart from the current net asset value of what the fund holds, thus creating discounts for most funds and, less commonly, premiums for some funds. The discount or premium is created because closed-end funds have a fixed number of shares that trade intraday on an exchange. Because the amount of shares is finite, they tend to trade at a discount or premium to the net asset value. Another factor to consider is that, unlike traditional open-end mutual funds, closed-end funds can use leverage as a means of boosting income distributions. “It's not unusual to see discounts start to widen when the markets start trending downward, and everybody wants to get out,” said Jeff Tjornehoj, head of U.S. research at Lipper. “It's a little like buying a stock, because you don't really know if the price is going up or down,” he added. In other words, with closed-end funds, the discounts represent how much value an investor would get when buying, but there is no guarantee that the discount won't continue to widen due to a falling share price. While much of the recent discount widening is likely attributable to panic selling, it's also important to keep in mind that discounts also can happen due to a rising net asset value. “Beyond just looking at the discounts and premiums, we think you should focus on whether you believe in the fundamentals of the asset class,” said Michelle Kelly, managing director at Tortoise Capital Advisors. “If you looked back over the past year or so, there definitely have emerged some opportunities,” she added. “But it's hard to know when these windows will open or how long they will last, and that's why you focus on the fundamentals of the category so you'll know what to do when you see the opportunities open up.”