Closed-End Funds Beckon to Savvy Investors

By CHARLES JAFFE

Jerry Paul is glad to be looking for investments that he knows most people ignore or avoid. It leaves more opportunities for him.

Paul, a founder of Essential Investment Partners LLC, a Denver- based wealth-management firm, is a former Morningstar Fixed-Income Manager of the Year who sees opportunities in closed-end funds that many investors overlook.

The rebounding stock market, increased merger activity, low inflation and possible deflation have combined to create buys in areas that most investors wouldn't think about. Paul has a unique perspective and approach in this area.

Closed-end funds are investments that, effectively, are built like mutual funds but trade like stocks. But where a mutual fund trades at its net asset value -- the current worth of all of its holdings divided by the number of outstanding shares -- closed-end funds trade based on sentiment. If the market doesn't think a certain fund is worth its net asset value, the fund will trade at a discount, allowing investors to buy a dollar's worth of assets for less than a buck.

If the market sentiment is likely to change and drive the fund back toward its true value -- or even to a premium -- investors can turn a quick profit. Throw in the attractive yields on many fixed- income, closed-end funds and you have a recipe for high potential returns on low-risk investments.

"Opportunities in closed-end funds have been more prolific in the last six to 12 months than I have ever seen," Paul said. "I don't think that will be replicated as we go into 2010, but there are going to still be lots of interesting things."

What Paul typically finds interesting are "special situations," cases where activist shareholders are basically trying to force the fund's board to turn the fund into an open-end issue -- immediately raising the price to the underlying net asset value -- or to go through liquidation or a buyout for a quick pick-up from a discount.

He also looks for "convergence trades," where a closed-end fund trades at a bigger discount than normal, making it a cheap buy that is worth holding until the price converges with the norm, turning the oversized discount into cash.

Identifying special situations can be hard, because seemingly every fund has conflict-of-interest issues.

Say a fund gets to where it is selling at a 15 percent discount, so that an investor can get $1 of assets for 85 cents; a closed-end fund investor would look at that situation and expect a 15 percent return. In fact, if the fund's manager can't generate a return that big elsewhere, he should be buying back shares of the fund, which would help close the gap and turn the discount into cash.

Alas, fund managers get paid based on the assets they have under management; when they buy back their shares, their asset size shrinks -- along with their own payday -- so most managers fight that kind of move until it is forced on them by dissident shareholders.

A big area where Paul sees opportunity right now is in municipal bonds, an arena that was beaten down last year.

"In general, the real return on bonds -- the yield after inflation -- is still extremely high," Paul said. "I get people looking at me cross-eyed sometimes when I say that, but if you can identify a municipal bond fund with a 6 percent tax-free yield on it, that's attractive."

One area Paul has moved out of is Treasury inflation-protected securities. He feels that the days of bargains on closed-end TIPS funds are gone for now.

"Any inflationary risks are some time away," Paul said. "We think TIPS are overpriced for inflation expectations; we owned a bunch of TIPS when they traded as if there was going to be deflation, but we have sold those recently as they got overvalued."

Chuck Jaffe, senior columnist for MarketWatch, can be reached at cjaffe@marketwatch.com or at Box 70, Cohasset, MA 02025-0070.

Originally published by CHARLES JAFFE Market Watch.

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