Remember the great recession? It's given way to the great rotation.
After years focusing on the bond market, many investors are plowing money into stock funds and ETFs, adding more than $104 billion this year alone, according to Lipper.
Yet while mutual funds and ETFs have reaped most of the benefits, closed-end stock funds may not be far behind — offering more upside potential, according to some veteran investment pros.
Like traditional mutual funds, closed-end funds hold baskets of stocks or other securities. The funds trade on the open market like stocks and their share price fluctuates around the "net asset value" of the fund's investments, often trading at a discount or premium price to the NAV.
When a fund is well-managed and trades at an attractive discount, investors often bid up the price closer to the NAV, which is where the opportunity lies in some closed-end stock funds, says Cecilia Gondor, chief investment officer of Thomas J. Herzfeld Advisors, an investment firm in Miami that specializes in closed-end funds.
Closed-end stock funds now trade at a 4.7% average discount, she says, compared to a slight premium for closed-end bond funds. Several stock funds trade more than 10% below their NAV. And Gondor says discounts could narrow: When investors pour money into traditional stock mutual funds, that's usually a good "leading indicator" that money will start flowing into closed-end funds, she says. If the rotation continues, closed-end share prices could rally.
"You want to get in when the discount is wide, before the great rotation has taken hold," she says.
In addition, some closed-end stock funds yield 6% or more, about three times the yield on the S&P 500 (.SPX). That can make these funds a good alternative to traditional stock funds, high-yield bond funds or other "risk" assets, says Gregory Neer, a closed-end fund analyst with investment firm Relative Value Partners in Northbrook, Ill.
Mind the downside
Still, closed-end funds can be risky, and it's important to understand the risks before investing. Many funds borrow money or use "leverage" in a bid to boost returns. But that can also amplify a fund's losses and add interest expenses for shareholders. Closed-end stock funds can be more volatile than traditional stock funds, and knowing when to buy and sell is key, says Mitchell Reiner, a financial adviser with Capital Investment Advisors in Atlanta who buys closed-end funds for some clients.
Reiner suggests investing in funds when their discounts are above their peer group or long-term average. If their prices spike to a narrow discount or premium it may be time to rotate into cheaper funds. And it's important not to panic if the share price dives temporarily due to a broad market sell-off, for example.
"If you don't have the discipline, you can wind up hurting yourself," he says.
Funds also have different policies for their distributions. Some are "managed," meaning they pay the same amount per share every month or quarter. Other funds pay distributions based on the performance of their underlying investments, which can vary.
Complicating matters further, some funds return investors' capital as part of their distributions. That may not be bad if the fund has a managed distribution policy and uses return of capital mainly as an accounting measure, says Relative Value's Neer. Distributions that include some return of capital also offer tax advantages since the returned capital isn't taxed (though it may lower your cost basis per share).
But analysts consider some types of return of capital to be "destructive," eroding the share price over time and lowering your total returns. If a fund's investments consistently fall short, it may return lots of capital — a sign of a poorly managed fund that you may want to avoid, says Gondor at Herzfeld Advisors.
However you invest, you should carefully evaluate the risks of each fund and how it may fit with your other investments. Most advisers recommend closed-end funds for a small part of a portfolio, typically no more than 10% or 20%.
You should consider the tax consequences too. Many funds pay short-term capital gains or other income that's taxed at ordinary income rates. If you're in a high tax bracket, that may make the funds more suitable for a tax-deferred account like an IRA.
The following are a few suggestions based on our research and interviews with industry experts. You should do your own research or consult an adviser before investing.
Closed-end funds on sale
One fund Gondor likes is Adams Express (ADX). Launched in 1929, it's one of the oldest stock funds on the market and has paid dividends continuously since 1935. At a 13% discount, the fund looks cheap, she says.
A large-cap fund, its top holdings include Apple (AAPL), JPMorgan Chase (JPM) and Lowe's (LOW). It also invests 4.5% in Petroleum & Resources Corp. (PEO), an affiliated closed-end fund that specializes in energy and natural resources stocks, a fund Gondor also recommends.
The fund's share price has risen 8.3% a year over the last 10 years, on average, slightly trailing the S&P 500. But Gondor sees some impetus for improvement.
The 84-year-old fund is now targeting a distribution yield of at least 6% based on the average month-end market price over the past 12 months. That could broaden its investor appeal and narrow the discount, she says. The company is also buying back shares, which could boost the share price.
The downside: The fund has been slightly more volatile than the S&P 500 over the past three years, according to Morningstar. If its investment income or capital gains fall short of its 6% yield target it may pay a lower distribution or return capital.
Tri-Continental Corp. (TY) is another closed-end stock fund worth a look, according to fund analyst Neer. Also launched in 1929, the fund uses a "quantitative" strategy that evaluates stocks based on valuation, price momentum and other factors. Apple, Verizon (VZ) and Microsoft (MSFT) are top holdings. Its remaining assets consist of convertible bonds and other income-generating securities.
Trading at a 13% discount, the fund hiked its quarterly distribution from 15 cents a share to 19 cents since last summer without returning capital. Its rising yield may help lift the share price, says Neer. Performance has been solid too: It beat 87% of peers over the last three years, climbing 16.4% a year on average, according to Morningstar.
The downside: While the fund doesn't use much leverage it has been more volatile than the S&P 500 over the past five years, according to Morningstar.
In the small-cap space, Royce Value Trust (RVT) earns a "gold" rating from Morningstar. Led by Chuck Royce — a 50-year industry veteran — the $1 billion fund holds around 500 small-cap stocks selected for "value" criteria such as low price/earnings and price/book ratios.
Returns have averaged 8% over the last 15 years, according to fund company Royce, beating the Russell 2000 index (.RUT) by more than two points. The fund trades at a 10.5% discount.
One notable feature: The fund's fee structure is based on the fund's trailing performance, notes Morningstar analyst Mike Taggart. Fees decline if the fund trails its benchmark index or posts negative returns over a certain period, and its overall expense ratio is low at 0.68%.
The downside: Performance has been volatile, including a 48.5% decline in 2008, according to Morningstar, and the fund may lag in a market than favors growth stocks.
AllianzGI Equity & Convertible Income Fund (NIE) branches out well beyond stocks. It holds around 70% in large-cap stocks and it supplements them with convertible securities that are a kind of hybrid between a stock and bond. It also sells call options against some stock holdings, for income and to help manage risk.
The fund may be a good fit for investors looking for more income, says Ben Wheeler, an adviser with Schwarz Dygos Wheeler Investment Advisors in Minneapolis. It returned an average 9.1% over the last three years, according to cefconnect.com, a closed-end fund research site. It doesn't use leverage and trades at an attractive 12%, discount says Wheeler.
The downside: The fund's option strategy caps the upside potential of its stock holdings. Its convertible holdings could lose money if interest rates rise.
Global "infrastructure" funds
Toll road operators, electric utilities and energy pipeline companies tend to be stable businesses that generate a lot of cash. They may not offer rapid growth, says the fund analyst Neer, but these infrastructure companies can be attractive investments benefiting from global economic growth.
Virtus Total Return Fund (DCA) invests in the space. It holds around 60% in stocks from the British telecom firm Vodafone (VOD) to Canadian energy pipeline operator Enbridge (ENB). The rest is in bonds and other fixed-income securities.
Gondor recommends the fund, noting its 12% discount has been narrowing in recent months. Through the end of 2012, returns averaged 23.5% over the prior three years, nearly four times the fund's benchmark index, according to Virtus. "It's a sleepy fund that will be discovered," predicts Gondor.
The downside: The fund is 26% leveraged, which could heighten losses in a down market. Performance has been volatile, including a 69.3% plunge in 2008, followed by rebounds in 2009 and 2010 of 36.8% and 53.7%. The fund's foreign holdings pose some currency risk.
Macquarie Global Infrastructure Trust Fund (MGU) also holds infrastructure stocks and yields around 6.2%. It invests in everything from pipeline operators to toll road companies and airport operators. The fund increased its quarterly distributions from 24 cents a share to 32 cents since last June — a sign of health, says Neer. It also looks cheap, he says, trading at a recent 10.1% discount.
The downside: The fund is 27% leveraged and its foreign holdings pose currency risk. Annual expenses are on the higher side at 2.39%.
|Fund name||Discount||Distribution rate||Expense ratio|
|Adams Express (ADX)||-13.0%||6.0%||0.62%|
|Tri-Continental Corp. (TY)||-13.1||3.9||0.45|
|Royce Value Trust (RVT)||-10.5||5.1||0.72|
|AllianzGI Equity & Convertible Income Fund (NIE)||-12.0||6.2||1.08|
|Virtus Total Return Fund (DCA)||-11.9||4.9||1.98|
|Macquarie Global Infrastructure Trust Fund (MGU)||-10.1||6.2||2.39|
Source: cefconnect.com; fund companies
Daren Fonda is Senior Writer and Investing Columnist with Fidelity Interactive Content Services, a provider of objective investing content on Fidelity.com. He does not own any of the securities mentioned in this article.