Spring cleaning in winter? It's that time of year when closed-end investors start culling their portfolios for losses that will help lighten their tax load next year. Often, that tax-loss selling creates opportunities for those waiting on the sidelines to buy closed-end funds on the cheap.
While prime time is still a few weeks away, closed-end fund specialist Thomas Herzfeld of Miami says you should start doing your homework now. "Don't step on the gas yet," he says. "They'll probably get a little cheaper in December, when the tax selling gets heaviest. Then you'll get a good rally in January, even if the market isn't doing well."
Like mutual funds, closed-ends hold securities whose prices fluctuate with the market. Their net asset value (NAV), or market value of the securities owned, also fluctuates. Closed-end funds differ from mutual funds in that they have a fixed number of outstanding shares, which trade on the stock exchanges.
The closed-end market trades inefficiently, so shares of such funds trade at prices that differ from NAV, often at discounts. The discounts typically widen at yearend and shrink again in January, creating the chance to make money not only on the fund's appreciation but on the narrowing discount: If its NAV is $10 and its market price is $8, the fund trades at a 20% discount. As demand for the fund's shares rises, so does share value. Ultimately, the discount is eliminated or bid up to a premium.
Right now, the best bets are surfacing in funds that invest in municipal bonds. Herzfeld moved his muni portfolio from an all-cash position to 30% in the past few weeks. He'll be 100% invested by mid-December, he says. Some recent buys include Managed Municipals Portfolio and Insured Municipal Income Fund, national funds with yields of more than 6%. That's the equivalent of more than 9% in a taxable bond for an investor in the 30% tax bracket. But a big risk remains: Rising interest rates are a negative for most bond funds, because prices move in the opposite direction of interest rates. When the portfolio is leveraged--as most closed-end muni funds are--that potential loss is magnified.
Closed-end investors considering funds to buy might also think about a few to dump. Outsized premiums often raise red flags. Investors have bid up the shares because of the astronomical yields they're paying. The high-yield Zenix Income Fund, which has a premium of 16.6%, also has a 16.7% yield. But payouts like that are unsustainable, says Don Cassidy, Lipper's senior closed-end analyst. "They're overpaying, and they're going to have to cut the dividend."
Interest-rate sensitivity aside, some discounts are simply a function of market mispricing. Adams Express, for instance, sells for a 11.8% discount, and for no good reason, says Amy Hawkins, director of closed-end fund research at Raymond James & Associates. The fund is on Hawkins' buy list: It's one of the oldest and most conservative funds on the market. It invests in large blue-chips such as American International Group, Coca-Cola, and Pfizer, and has a 10-year average total return of more than 11% on NAV and 10% on price. Another Hawkins recommendation is the meVC Draper Fisher Jurvetson Fund I: Its venture-capital holdings in technology startups are very risky. But at a 32% discount, she says the shares trade below cash value, making it attractive for investors seeking a speculative bet.
Many closed-end equity funds are also selling for big discounts. As attractive as that may be, a stock fund may not be a bargain if its underlying assets--say biotech or Thai equities--are heading south. But if you're bullish on stocks over bonds, "then it's a good time to get into closed-end funds," says David Barron, head of closed-end funds for J.P. Morgan Fleming Asset Management. He's keen on European closed-ends, which in some cases are selling at double-digit discounts, including the European Warrant and the France Growth funds. When those markets recover, investors will be rewarded twice.
By Mara Der Hovanesian