In 1924 there were no fax machines, email or cellphones. There also weren’t easy ways for common people to invest their money. This was the Roaring 20s and people wanted their share of the excitement. The solution was to create three types of investment trusts known as unit investment trusts.
All three trusts express their value at the end of the day by posting the Net Asset Value (expressed as “NAV”). The process in all three cases is that as an investor, you buy a unit of a trust and the trust owns the underlying securities. They could be stocks, bonds, money markets, or all three.
In the case of the unit investment trust, which most exchange traded funds (ETFs) mimic in the process, you invest in a portfolio of securities that are stagnant inside the trust. This means the portfolio manager does not have to actively manage the investments selected, because there is typically very limited, if any, additional buying or selling. You are told the NAV every day and you know precisely what your fees and expenses will be.
Open-ended mutual funds have you, your neighbor and the retiree down the street all put money into a trust commonly called a “fund.” There is a manager or team responsible for taking your cash investment and buying and selling securities at their sole discretion. When you want to withdraw your money — or, to use the industry word, “redeem” your investment, the fund is responsible for ensuring that there is cash to pay the fund holders’ redemptions.
A closed-end fund functions exactly the same way with one notable exception: You sell the investment on the exchange rather than the fund cashing you out. This condition creates a natural fluctuation in price and presents both opportunities and notable risks.
We use closed-end mutual funds (“CEFs”) when the opportunities arise. Usually, that occurs with rapid downward market movements.
CEFs tend to trade at a discount to their NAV, because you have to sell the investment rather than redeem. Very rarely do they trade at a premium (more than their NAV) but it can happen.
When markets decline, investors without discipline often panic as they did in both December 2018 and May of this year. When someone panics, the typical call the broker receives is “sell it all!”
CEFs typically don’t have large trading daily volumes on a normal day and as a result, have low volume. When markets turn down, many times the discount on the CEF increases because panicked sellers are selling too many shares to the market at one time. This creates a double opportunity.
Stocks went down in value as the market dropped both outside the fund and the portfolio holdings inside the fund. That allows you to buy at a lower price. The panicked sellers caused the discount to increase, giving you even more potential buying power.
Please note there are risks in redeeming because of volume but it is another strategy you can use.
Joseph “Big Joe” Clark, whose column is published Sundays, is a certified financial planner. He can be reached at firstname.lastname@example.org or 765-640-1524.