Pennies on the Dollar — Purchasing Closed-End Funds at a Discount to their Net Asset Value

Everyone loves a sale. Whether it's a new car or just a new pair of shoes, we often jump at the opportunity to pick up quality goods at substantial discounts of 10% to 20% off their ordinary, everyday price.

But while being a coupon-clipping shopper can save you a few bucks, learning to be a price-conscious investor could make you a multi-millionaire.

However, the road to financial success is often a rocky one, especially for value investors. Although it's easy to count your savings when you're holding a 20%-off coupon from your local supermarket, it is much more difficult to find investment securities that are trading at a steep discount to what they're really worth.

Fortunately, there's one type of security that is perfectly transparent. It allows investors to calculate its EXACT value — down to the very penny. Even better, as we go to press, 63 of these securities are now trading at discounts of at least 10% relative to the value of their underlying assets.

We're speaking, of course, about closed-end funds (CEFs). In today's issue, we'll explain how these discounts come about — and how you can take advantage of them to profit handsomely from today's market environment. We'll also provide a detailed look at two outstanding equity funds that are both trading well below their net asset value (NAV), giving investors the chance to purchase a solid basket of assets for just pennies on the dollar.

Wall Street's Bargain Bin
Traditional open-end mutual funds and their closed-end cousins share many common traits, but also a few key differences. For example, CEFs are more liquid, can use leverage to boost returns, and don't have to raise cash to meet shareholder redemptions.

Of course, the most striking difference is that open-end mutual funds trade precisely at their net asset value (NAV). By contrast, CEFs can — and often do — trade above (premium) or below (discount) the value of their underlying assets.

While there will be situations in which it is acceptable to buy funds changing hands at a premium, it is generally more advantageous to look for those that are currently on sale. After all, if the net value of the securities in a fund's portfolio breaks down to $10 per share, yet its current market price is just $9, then investors are being handed the rare opportunity to scoop up $1 worth of assets for just 90 cents.

When Mr. Market tosses a stock in the bargain bin, it's often because the company has suffered deteriorating operating performance or is facing some other obstacle. However, this isn't necessarily the case with closed-end funds — many funds with rock-bottom price tags happen to be top-tier performers.

Because CEFs trade on the open market, they are subject to the whims of supply and demand. As such, there is typically a discrepancy between price and value — sometimes a wide one.

For example, investors interested in China Fund (AMEX: CHN, $42.11) in December 2004 had to pay a steep +30% premium to climb on board. However, the exact same fund is now available at an attractive -11% discount.

There is no single reason to explain this curious phenomenon, but academic studies have isolated several contributing factors, most notably: relative performance, embedded unrealized capital gains, investor sentiment, rights offerings, scarcity of competing funds, the name brand recognition of the manager or fund company, and the existence of a managed distribution policy.

The relationship between these factors and fund pricing is outside the scope of this article. Suffice it to say that regardless of the cause, heavily discounted funds can often be a reliable way to put extra cash in your pocket.

Two for the Price of One
Over the past three years through May 30th, the average open-end domestic stock fund has delivered annualized returns of +13.3% — a pretty good showing in absolute terms. However, over the same period its closed-end counterpart has posted even stronger gains of +17.0% per year.

This pattern is nothing new — nor is it limited to domestic equities. In fact, CEFs have topped open-end funds in a wide variety of performance categories over the long haul. This outperformance can be attributed to several factors, but it's a safe bet that in many cases shrinking discounts played a major role.

Certainly, the math behind this process is simple enough to understand. Here's a common example:

A fund (often in an out-of-favor category) is trading at a sizeable discount when its particular corner of the market suddenly begins to rally. First, that will cause the fund's net asset value (NAV) to rise. Then later, as the asset class continues to gain favor, other investors will begin to pile in — causing the discount to shrink (and in many cases a premium price to emerge).

Of course, this isn't the only scenario — discounts can disappear for many different reasons. Over time, it only makes sense that the gains in a fund's portfolio and the price change of its shares will end up at least somewhat at parity. But regardless of the underlying cause, the combination of a rising NAV and shrinking discount can be powerful.

Consider the case of Chile Fund (AMEX: CH, $20.35). In early 2005, the fund was changing hands at a wide discount of 10% - 12%. However, during the course of the year a rally in the Chilean market pushed the fund's NAV ahead nearly +19%. Meanwhile, the discount began to quickly evaporate, eventually becoming a +24% premium by the end of the year. With the NAV climbing and the discount shrinking, CH delivered a hefty total return of +65% that year.

In other words, the fund's investments climbed almost +20% for the year — an impressive performance. But as the fund's price discount turned into a premium, shareholders enjoyed actual gains of more than three times that size!

More than Meets the Eye
Clearly, buying cheap has its advantages. In fact, the discount/premium figure can be one of the most important criteria when analyzing the investment merit of a CEF. However, this is only part of the picture — buying at a discount can also be a gift that keeps on giving over time.

For example, consider the hypothetical fund mentioned briefly above — with a $9 market price and $10 NAV. Suppose the fund issued total dividend distributions of $0.50 over the past year. Yields are typically calculated based on NAV, so the fund would be quoted as having a yield of 5.0% ($0.50/$10.00).

However, because of the 10% discount, investors would only be paying $9 per share — so the effective yield on their investment would be an even stronger 5.55% ($0.50/$9.00). And as long as the shares remain discounted, all future dividend distributions can be reinvested at the reduced price, leading to magnified gains when the market price of the shares eventually converges with its NAV.

Choosing a Winner
At the moment, of the 150 or so CEFs that target domestic stocks, the average fund is trading at a discount of -2.4% — but nearly three dozen have attractive double-digit discounts. And overseas the story is even more promising: the average discount is -5.5% and nearly 30 funds have discounts of at least -10%.

However, discounts are only part of the bigger picture. When sifting through this group, be sure to also keep the following factors in mind.

Asset Allocation: When shopping, there is little sense in buying something we don't need simply because it is on sale — the market is no different. When scouting for new funds, first be sure that they fit within the framework of your asset allocation and overall portfolio objectives.

Relativity: Remember to always compare a fund's discount to others within its category. A hefty 10% discount might look compelling at first glance, but not if a competing fund with similar performance and style carries a 12% discount.

Channel/Range: Many (but not all) funds tend to trade within a historical range relative to their NAV. Some traders use this as a timing mechanism, buying funds trading at the low-end of the range (when discounts are largest) and selling at the high-end. While we generally discourage this type of short-term speculation, tracking a fund's historical discount/premium trading range can be helpful when used in conjunction with other analytical tools.

Fundamentals: It is seldom a good idea to buy a fund based solely on its discount without first evaluating its fees, performance and other factors. After all, making $1 from a shrinking discount is of little consolation if the fund's NAV slips $2. Above all, the fund should be able to stand on its own without the discount.

With all this in mind, we recently sifted through more than 100 sharply discounted funds to find a handful of the most promising. In the table below, you'll find a snapshot of these finalists. And in the text that follows, we'll profile two of our current favorites.