If you’ve ever played pick-up Basketball, you know Closed-End Funds. Think of the players, more specifically, the odd man out. Let’s say he’s your wife’s best friend’s new boyfriend. You invited him because, well, he seemed alright. The practice shots begin and no one pays much attention. You chat and warm up until a sense of boredom and restlessness arrives. Now comes the draft. First off the board are growth stocks; the FANGs of today’s market. Next, the safety and ingenuity of an unconstrained portfolio reigned over by the day’s bond-king. A match for the ages.
The second round is for shoring up the weaknesses inherent in the high flyers and go-anywhere genius of the first; index funds are picked for the reliability of a broad diversity of skills and a low floor of costs to the team. Boring value stocks and consistent, if not inspiring, dividend dogs are pulled in next. Round four is for covering any blind spots and as the saying goes, ” Defense wins championships.” This removes alternatives and cash, respectively.
Time to pick a poison, the captains suppose. Now that we are in deep value territory, it is the goal to avoid the landmines and Italian automobiles. The ninth pick is in, and it is a junk bond fund. With a paltry yield enhancement, the team must burden a possible default. On to the last man standing. He looks like he’s ready to place second in a badminton tournament, but you pray that you can manage the game around him with proper strategy. He is the human incarnation of a closed-end fund.
A closed-end fund is a bit wonky, a bit underappreciated and quite misunderstood. No matter how eccentric, they have a a transparency stocks cannot buy- a visible margin of safety. Think of SPY, the S&P 500 etf. It is a fund that trades on an exchange and mirrors the Standard and Poor’s Large-Cap Index. Now imagine that fund having a fixed size, as opposed to a mechanism to create daily liquidity. Voila.
As a sort of exchange traded fund, they have both a readily available market value and book value. At the begining of every trading day you can quantify a margin of safety. You can actually buy $1 of S&P 500 assets for $0.90 or less. Well that seems too good to be true, you think as the last man picked goes 5/5 from behind the arc. Well, it can be. See, a closed-end fund could fall to a lower discount to it’s book value. A good rule of thumb is to look at a long term chart and, as they say, “buy high and sell low”.
Although they have serious drawbacks like low liquidity and relative lack of scaleability, they can still be an investor’s friend. Besides the conclusion that $1 buys you more than $1 of earning power, Closed-End Funds can be a valuable indicator. Why? Because like a pick-up basketball game, they are often the last one’s picked in a bull market.
If you’ll come aboard my train of thought for a moment, I’ll explain. The back end of a bull market is usually characterized by too much capital chasing too little value. Much like a collapsing junk bond spread, investors tend to erode their margin of safety in favor of yield because at that particular moment, nothing seems risky. Capital is easy and that causes asset prices to rise. Once yield spreads fall to the floor and stock market multiples float to the ceiling investors start to look elsewhere for value. Closed-End Funds tend to fill that void.
Let’s say our earlier example of an S&P 500 Closed-End Fund trades, on average, at a discount of 15%. At this point in the bull market it may be trading at a discount of 5%, or even, yes, a premium. At that point you must know that the seesaw is no longer level. Why would anyone, in their right mind pay $1.05 for $1 of stocks? They have too much capital and too little affinity for preservation of that capital.
That is the point one may realize that capital has been so easy that investing becomes hard.