How to Buy a Dollar for 85 Cents
No matter how many times you slide a dollar bill into a change machine, you should always get four quarters back. It's just the way things work in the real world.
Thankfully, there are pricing discrepancies on Wall Street. There, you can buy a dollar's worth of stocks for $0.85 -- or perhaps even less than that. All you need to do is warm up to the sorely neglected realm of closed-end funds.
Open-ended Potential
What is a closed-end fund? Unlike traditional mutual funds, where shares are issued and redeemed on a daily basis, closed-end funds have a set number of shares outstanding. They also trade on stock exchanges throughout the day, like their more popular exchange-traded fund (ETF) cousins.
Closed-end funds have always gotten short shrift. They aren't actively marketed the way open-end funds and ETFs are. However, thrifty investors can't ignore that most of the general stock-based closed-end funds trade at a discount to their net asset value -- or NAV.
There are hundreds of closed-end funds, taking up two full pages of weekly quotes on Barron's. Only about a third of closed-end funds are equity-based vehicles, with the balance dedicated to fixed-income offerings.
There is a big operating advantage to closed-end funds over conventional mutual funds. Since the outstanding shares remain constant, a closed-end-fund manager doesn't have to worry about cashing out redemptions when times are bad or putting new money to work when the going is good. Fund managers can stick to their investing philosophies, remaining fully invested during the inevitable market volatility.
Since there is no incentive to spend on marketing, closed-end-fund expenses can be fairly reasonable. The problem -- and also the opportunity -- is that this makes closed-end funds poorly promoted investment vehicles.
Toiling away in the shadows means that many of these funds trade for less than the value of their portfolios, unlike open-ended funds that are bought and sold at the exact NAV.
Fun with Funds
Let's use Adams Express (ADX) as an example. Adams Express has been around since 1929, and it's been consistently paying dividends since 1935.
The closed-end fund closed at $9.35 on Friday. Its NAV -- the value of its assets minus its liabilities -- closed out the week at $11.01 per share. The stock is trading in the open market at a 15% discount to its theoretical liquidation value -- giving buyers a dollar's worth of stocks for $0.85.
Investors aren't buying snake oil, either. Adams' largest holdings include household names such as Apple (AAPL), McDonald's (MCD), and PepsiCo (PEP).
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How does buying Apple at a 15% discount sound? Well, Apple accounted for just 2.8% of the fund at the end of June. However, getting more bang out of your buck by buying into this basket of established stocks has to be a tantalizing proposition.
Tri-Continental (TY) is another fund trading at a 15% discount. Apple, Microsoft (MSFT), and Chevron (CVX) were its three largest holdings at the end of August. Tri-Continental also launched in 1929, and its 0.6% expense ratio compares favorably with the average open-ended mutual fund.
Fund investors may be familiar with value investor Charles Royce. He watches over the popular Royce family of open-ended mutual funds. Did you know there are three Royce closed-end funds, owning many of the same stocks that the traditional funds do but at a 13% to 15% discount to NAV?
There's no free lunch
There is a catch, and it's a pretty big one. The only reason you can buy into Adams Express or Tri-Continental for $0.85 on the dollar is that an earlier investor is willing to sell them to you on the same terms. In other words, buying in at a 15% discount doesn't mean you'll be able to cash out at full price.
Only a liquidation event would make that possible, at which point I should once again remind you that these funds have been around since 1929.
However, the operating advantages of closed-end funds and the leveraged nature of the discount should be enough to intrigue you into digging a little deeper. Just because most investors ignore closed-end funds, that doesn't mean that you should miss out on the opportunity to get more bang for your buck.
Longtime Motley Fool contributor Rick Munarriz owns no shares in any of the stocks in this article. The Motley Fool owns shares of Apple, Microsoft, and PepsiCo. Motley Fool newsletter services have recommended buying shares of Chevron, PepsiCo, Microsoft, McDonald's, and Apple, creating a bull call spread position in Apple and Microsoft, and creating a diagonal call position in PepsiCo.
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