For reasons economists don't fully understand, the shares of closed-end mutual funds often trade below the value of the underlying investment portfolio. This has long left investors wondering whether it's wiser to buy the funds when they're at severe discounts and wait for most of the gap to close, or to trade more frequently, hoping to capture lots of little gains. "The question has been around for years," says Gregg Wolper, Morningstar's closed-end funds expert. "How can you use closed-end discounts in a strategy that will consistently work?"
Now, two University of North Florida professors offer an answer. In an as-yet unpublished study, Seth Anderson, a finance prof who has studied closed-ends for three decades, and B. Jay Coleman, a professor of operations management and quantitative methods, say they've isolated which strategies take best advantage of closed-end fund discounts--and which do worst. Unlike open-end funds, which sell and redeem shares at their current net asset value, closed-end funds trade like stocks, usually on the New York Stock Exchange (NYSE).
"EXPLOITABLE." Anderson and Coleman examined how a hypothetical $100,000 account would have performed using 244 distinct trading strategies. They checked results in up to 54 U.S. equity closed-end funds over six five-year periods from January, 1967, through December, 1996. They also tested the strategies using low, moderate, and high commission rates. The outcome? The profs outperformed the Standard & Poor's 500-stock index in 85.6% of the 4,329 cases they looked at. Although one strategy trailed the market by 36.6%, the best beat the index by 525%. "Such results strongly suggest the existence of an exploitable market anomaly," Anderson and Coleman say.
The two, who expected to find that buying at deeper discounts led to higher returns, were surprised to learn the best results came from selling after relatively small moves--only two or three percentage points. They're not sure why, but the most profitable of these narrow-spread strategies was to buy closed-end funds at a 21% discount and then sell when the gap narrowed to a 19% discount. The worst was to buy at a 3% discount and sell when it reached zero. Any single move of three points is better than one of two points, but in testing these tactics, what counted was which offered the most chances for profit over five years.
Trading funds this way is not for everyone. "Jumping in and out requires a lot of work," says Reuben Brewer, manager of the Value Line Mutual Fund Survey. "You have to have a serious temperament for it, and you need a lot of time." Wolper notes, too, that the professors didn't adjust their results for the capital-gains tax liabilities such a strategy could create, or the trading spread--the difference between the price a fund can be bought and sold for at any given moment. Anderson says those costs would cut into profits, but not enough to invalidate the findings.
Just the same, some pros say they've enjoyed good results operating precisely as Anderson and Coleman describe. "We look to get two, three, four percentage points at a time and do as many trades as we can a year," says Thomas Herzfeld, a Miami investment adviser specializing in closed-end funds. John Bowling, an adviser in Cincinnati, agrees but says closed-end fund trading "lends itself better to tax-free accounts," where capital-gains levies can be deferred.
Tempted to trade closed-end funds? You need no more than $50,000--enough for fair stakes in four to eight funds. Fewer than four would not offer enough diversification, Anderson says, while more than eight would be hard for an individual to follow.
Amateurs do enjoy one advantage over pros who run portfolios in the hundreds of millions of dollars. The pros avoid the closed-end market because trading is relatively light, so big orders disrupt prices. But for typical orders, "the spreads are becoming smaller," Herzfeld says, from 1/16 to 1/4 of a point for, say, 1,000 shares at $10 on the NYSE. That works out to $62.50 to $250 on a $10,000 investment. Add that to the broker's commission when figuring the total transaction cost for each trade.
Individual investors benefit from more data on closed-end funds via the Internet. Morningstar's site, www.morningstar.net, offers lots of free market data on 460 closed-end funds, with more analysis and detail available to subscribers who pay $9.95 a month. At Site-By-Site! (www.site-by-site.com), you'll find a free clearinghouse of news, weekly reviews, and commentaries, plus rankings and profiles of most closed-end funds. All these sites note discounts and premiums, usually calculated weekly.
Some solid, free information, including a discussion forum and a tutorial, is available at Internet Closed-End Fund Investor (www.icefi.com). Subscriber services, starting at $20 a month, cover in great detail nearly the entire universe of 500-plus funds. Sam Raja, a software consultant in Pasadena, Calif., and an active trader in closed-end funds, has been operating the site for five years but counts just 400 subscribers. "It's more of an elitist thing," he says. But the site could help ordinary investors who want to test the latest theory on how best to make money in closed-end funds.