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On March 21, 1924 three Boston businessmen pooled together $50,000 to form a company called the Massachusetts Investor's Trust. The purpose of the company: to invest in the roaring 1920s stock market boom. These three men unwittingly gave birth to a financial revolution. In fact, in the ensuing 80 years their invention, the mutual fund, has come to dominate the retail investing landscape. From those humble beginnings, mutual funds have grown into a dominant force in the U.S. investing landscape. As of July 2005, total assets in U.S. funds totaled nearly $8.5 trillion dollars, a number equivalent to more than three-quarters of U.S. Gross Domestic Product (GDP). But while mutual funds are enormously popular, there's another lesser-known type of fund that's been around even longer. This variety of fund has been in existence since at least mid 19th century Britain. But with only $371 billion in assets in the U.S., this phantom fund class is only about 5% the size of the mutual fund industry. Nonetheless, the group holds several major advantages over mutual funds. Even better, due to a quirk in the way these funds trade, investors periodically have a chance to buy great investment assets at an enormous discount to their current market value (more on this topic in a moment). The Good and Bad of Mutual
Funds
And, of course, mutual funds have the benefit of economies of scale. Managers have access to expensive research, can trade in large blocks at ultra-low commission rates and can afford to hire a staff to constantly monitor their positions. Few individuals can afford that type of quality research as well as that commitment to daily analysis. But mutual funds aren't perfect. In fact, they come with the following unique set of disadvantages:
Enter Closed-End Funds There are only about 800 closed-end funds in the U.S., and these funds boast less than $400 million in assets. That compares to roughly 8,000 U.S. mutual funds with close to $8.5 trillion in assets. However, despite their lack of popularity, closed-end funds could make valuable additions to just about every investor's portfolio. Unlike mutual funds, closed-end funds are listed on one of the major exchanges -- in most cases, the New York Stock Exchange (NYSE). You can buy shares in a closed-end fund directly from your broker, and when doing so, you can generally expect to pay the same commissions you'd pay to buy a normal stock off the exchange. There are no up-front sales charges or fees for early redemptions. Better still, closed-end funds trade throughout the normal 9:00 AM to 4:30 PM ET trading day, so you can buy and sell shares in a closed-end fund at any time you wish. And, of course, there are no minimums. You can buy closed-end fund shares in any amount you desire. Many are highly liquid and trade hundreds of thousands of shares every day. When purchasing a closed-end fund you can buy as little as a single share or many thousands of shares if you'd like. Closed-end fund managers also don't have to cope with the constant influx and redemption of cash investments. When a fund lists on the exchange, it raises a certain amount of capital just like a normal stock in an initial public offering (IPO). Investors in a closed-end fund can't ask for their investment back -- they can only buy and sell their shares in the open market. Transactions in the open market don't affect the actual cash the company has on hand to invest. This means that closed-end fund managers essentially have a fixed pile of cash to work with. They therefore don't have to cope with the daily inflows and outflows of cash that mutual fund managers do. As a result, their expenses and fees are typically much lower than for mutual funds -- often as low as 0.75% of assets annually. And, of course, closed-end funds offer many of the same advantages as mutual funds. These include instant diversification, professional management expertise and the lower trading commissions and research efficiency that comes with size. Like mutual funds, closed-end funds offer investors a chance to invest in many different strategies, regions and industries -- some funds focus on particular international markets, different classes of bonds or specific strategies such as income investing. In fact, one of the big benefits of closed-end funds is that they can give investors access to foreign markets and global bonds that would be very difficult for individual U.S. investors to buy directly. A Profitable Quirk Closed-end funds trade on the major exchanges just like stocks. Their price is determined not by the value of the investments they hold but by the supply and demand for each fund's shares. Let's illustrate with a simple example: suppose you hold a closed-end fund that owns 100 shares of IBM trading at $100 per share. The value of that investment is $10,000. This figure is referred to as the fund's net asset value (NAV). Furthermore, let's assume that the closed-end fund in question has a total of 1,000 traded shares. In this particular example, the fund's NAV per share would be $10. However, just because the fund's investments are worth $10 per share does not necessarily mean that the closed-end fund will trade at $10. If investors sell the fund's shares en masse, then the price of the fund on the open market could well drop to $9 -- in this case, the fund would be trading at a 10% discount to its NAV. On the flip side, if investors, caught in a bullish mood, decide to buy the shares with abandon, then the fund could trade up to $11 or $12 per share. In this type of situation, the fund could sell at a premium to its NAV. Although it might seem as though closed-end funds should trade at or near their NAV at all times, in practice this is definitely not the case. In the past, I've seen funds trade at premiums or discounts of more than +/- 20% of NAV for short periods of time. Over the long term, however, closed-end shares do tend to revert to their NAV. In some cases, in fact, closed-end fund management companies will try to speed up that adjustment by actually buying back their own shares if they're trading at a discount to NAV. Meanwhile, some hedge fund managers have been known to actively short-sell closed-end funds that are trading at big premiums to their NAV. It's a good idea to try to buy funds that are trading either at discounts to their NAVs or at levels very close to their NAV. If you can buy a fund at a discount, then you're essentially buying that fund's assets -- the stocks and bonds held by the fund -- at a bargain price. In this case you stand to profit if and when that discount window is ultimately closed. On the flip side, as a general rule of thumb, funds that are trading at premiums of 3% or more to their NAV should probably be avoided. In the table below, I list a number of promising closed-end funds, some basic information about these funds and their current premium or discount to NAV. And in the text that follows, I provide a closer look at nine of my favorite closed-end funds, many of which focus on a variety of unique strategies... Editor's Note: To view the remainder of this article, in which StreetAuthority.com founder Paul Tracy and his staff provide a table of 30 high-quality closed-end funds, as well as in-depth profiles of their nine favorite funds from this list, you'll need to subscribe to our premium Market Advisor newsletter. Please visit one of the following links to continue... Good investing!
Paul Tracy founded StreetAuthority and became Editor in Chief in 2001. Prior to that he spent several years as Managing Editor at a multi-million dollar financial publishing firm with over 150,000 subscribers. In addition to his role as managing editor and lead financial writer, he was also responsible for equity research and managing a team of seasoned professional financial writers, researchers and market commentators. Paul's previous experience includes a position at Robert W. Baird & Co.'s full-service brokerage operations as well as economic research work on a Money and Banking project funded by the National Bureau of Economic Research. He has also spent time doing outside consulting and research for the University of Virginia, has appeared as a guest expert on several prominent financial radio shows, and has been a featured speaker at various investment conferences across the U.S. Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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