Like ETFs, closed-end funds invest in a package of securities and then trade like stocks. Unlike ETFs, closed-ends don’t have mechanisms designed to ensure that their share prices closely track the value of the funds’ assets, or net asset value (NAV). So it’s not uncommon for a closed-end’s share price to trade for a significant premium to (or discount from) its NAV. Clever investors try to take advantage of these pricing anomalies by buying closed-ends when they trade at big discounts and selling when the discount narrows or turns into a premium.
What could go wrong: Quite a bit. The securities the fund owns may head south. You may buy a fund at a discount to NAV, then see the discount get wider. Or you may be willing to buy what you think is an exceptional closed-end at a premium to NAV, only to see the price swing to a discount. Moreover, closed-ends, especially those that own bonds, often borrow money to improve their results. But leverage works both ways and can decimate returns if the market turns against you. With closed-ends, “the highs are higher and the lows are lower,” says Morningstar analyst Cara Esser.
How to play them: Bill Gross may have left Pimco, but the firm still offers plenty of superb closed-end funds, says Esser. “Pimco’s fixed-income team remains very solid,” she says. The problem is that many of Pimco’s closed-ends are so popular that they trade at premiums to NAV. Look carefully, though, and you can find a few selling at discounts to NAV. Pimco Dynamic Income Fund (PDI, $29, 8.0%), which employs leverage and invests in bonds from all over the world, including non-agency-backed mortgage securities, trades at a 5% discount to NAV. Pimco Dynamic Credit Income Fund (PCI, $20, 9.2%) sells for 10% below its NAV. Also leveraged, the fund has big slugs in non-agency mortgage securities, junk bonds and emerging-markets bonds.
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High earners can choose from nearly 200 municipal closed-end funds, many with similar names. Pimco, for example, runs three national tax-free funds with “Municipal Income” in their names. We suggest Pimco Municipal Income II (PML, $12, 6.3%), which trades right around its NAV. About half of the fund’s assets are in muni bonds with maturities of five to 10 years; thanks to leverage, the fund’s average duration is a fairly high 11 years. But for a taxable-equivalent yield of 11.1% for investors in the highest bracket, the fund may be worth the risk. Nuveen is also known for its muni funds. One of its tamer offerings is Nuveen Municipal Income (NMI, $12, 4.3%). The fund employs just a small amount of leverage and thus has an average duration of just 7.6 years. It trades at a 4% premium to NAV. The taxable-equivalent yield is 7.6% for the highest-bracket taxpayer.
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