Understanding closed-end funds
Closed-end funds (CEFs) have consistently attracted the attention of investors due to their potential for mispricing in the market. In his book, A Dollar for Fifty Cents, author Michael Joseph highlights the complexities involved in investing in these funds. He cautions that simply buying CEFs at a discount does not ensure a profitable outcome. Joseph argues that relying exclusively on the depth of the discount to net asset value (NAV) or on high yields may result in significant losses for investors.
Understanding the risks involved
Joseph, the Deputy Chief Investment Officer at Stansberry Asset Management, emphasizes the risks inherent in closed-end funds (CEFs). He warns potential investors about the speculative nature of these investments, particularly regarding the hope that an activist investor will step in to rectify any discrepancies in net asset value (NAV). Additionally, he advises against purchasing a CEF at its initial offering, as this can frequently lead to misguided decisions. The recent volatility in interest rates serves as a case in point, with significant declines in the valuations of leveraged municipal bond CEFs occurring during the Federal Reserve’s interest rate hikes in. This situation highlights the importance of exercising caution when investing in CEFs.
Historical context and learning from the past
The title of Joseph’s book serves as a metaphor for the investment landscape, reflecting the renowned investment narratives of Warren Buffett and Charlie Munger. Following the market downturn of 1969-1970, Buffett and Munger took a significant stake in Source Capital, which was trading nearly 50% below its underlying asset value. Their bold investment ultimately yielded substantial returns. However, Joseph cautions readers that such deep discounts are rare. He cites research indicating that a more pragmatic strategy involves targeting a 20% discount, with the intention to sell when that discount narrows to 15%.
Navigating the closed-end fund landscape
This 89-page guide aims to be accessible to both novice and seasoned investors, offering insights into the complexities of closed-end funds (CEFs). Joseph synthesizes literature and academic perspectives to address the phenomenon of CEFs trading below their net asset values (NAV). In particular, he explores the rise of CEFs with specified termination dates, which theoretically enable investors to redeem shares at NAV at a predetermined time. However, he notes that these termination dates can often be extended, adding an additional layer of complexity for investors.
Tools and strategies for investors
Joseph offers practical tools for investors, including free screening websites that improve the selection process for closed-end funds (CEFs). He emphasizes the importance of being cautious about misleading fund names and distribution rates, which can protect investors from potential pitfalls. The subtitle of the book, Proven strategies to outperform the market with closed-end funds, highlights research suggesting that CEFs may provide superior returns. However, those seeking a contemporary track record of index-beating management based specifically on CEFs may find limited satisfaction. Instead, the author shares insights derived from broader market trends rather than specific performance metrics.
The role of closed-end funds in investment portfolios
Despite the challenges associated with closed-end funds (CEFs), many financial experts recognize their potential value within diversified investment portfolios. One of the primary advantages of CEFs is their ability to provide diversification in income-focused portfolios that also include bonds, preferred stocks, and real estate investment trusts (REITs). CEFs that increase their distributions over time can help investors maintain purchasing power in the face of inflation, making them an attractive option for those focused on income generation.
Michael Joseph’s balanced portrayal of the strengths and weaknesses of CEFs equips investors with the knowledge necessary to navigate this unique segment of the market effectively. By understanding both the potential rewards and risks, investors can make informed decisions that align with their financial goals.