Confessions Of A Closed-End Fund Bargain Hunter

Forbes

Classical economics: All actors are rational and stocks are efficiently priced. Behavioral economics, per Nobelist Richard Thaler: Investors’ decisions are warped by emotion and ignorance and prices can get out of line.  Count Erik M. Herzfeld, a money manager specializing in closed-end funds, in the Thaler camp. He aims to buy when fund shares trade at an irrationally low percentage of liquidating value and sell at a high percentage. Unlike mutual and exchange-traded funds, closed-ends don’t do redemptions, and their prices are a matter of investor whim.   “Big discounts and big premiums. It’s behavioral,” Herzfeld says. “No one reads prospectuses.” Or rather, he reads and retail investors don’t.  Read the full story on Forbes: https://www.forbes.com/sites/baldwin/2023/10/02/confessions-of-a-closed-end-fund-bargain-hunter/?sh=22f26a6c1111  Subscribe to FORBES: https://www.youtube.com/user/Forbes?sub_confirmation=1  Fuel your success with Forbes. Gain unlimited access to premium journalism, including breaking news, groundbreaking in-depth reported stories, daily digests and more. Plus, members get a front-row seat at members-only events with leading thinkers and doers, access to premium video that can help you get ahead, an ad-light experience, early access to select products including NFT drops and more:  https://account.forbes.com/membership/?utm_source=youtube&utm_medium=display&utm_campaign=growth_non-sub_paid_subscribe_ytdescript  Stay Connected Forbes newsletters: https://newsletters.editorial.forbes.com Forbes on Facebook: http://fb.com/forbes Forbes Video on Twitter: http://www.twitter.com/forbes Forbes Video on Instagram: http://instagram.com/forbes More From Forbes:  http://forbes.com  Forbes covers the intersection of entrepreneurship, wealth, technology, business and lifestyle with a focus on people and success.

Transcript

00:00 I'm William Baldwin. I cover investing for Forbes. And I'm going to be talking today with an expert

00:06 about closed-end funds. This is going to be Eric Hertzfeld, who is president and portfolio manager

00:14 of a Miami Beach, Florida firm that does almost nothing but closed ends. They really know this

00:19 stuff inside and out. So Eric, I'm going to ask you a bunch of tough questions, but I'm going to

00:23 start by asking you some easy questions. What is a closed-end fund? Some of our audience don't know

00:29 exactly the difference between that and a regular fund. It's a question we often get. I think the

00:34 main thing to think about is really is a closed-end fund is really just an open-end fund, a mutual

00:40 fund, but instead of it being redeemed and trading, it trades basically on an exchange. So you can

00:46 think of it as an open-end mutual fund that's actively managed, but that fund trades on an

00:53 exchange. So instead of redeeming and getting in and getting out of the securities through an

00:59 issuer, such as MFS, for instance, you can buy and sell your shares on an exchange.

01:06 So Eric, what's the deal here? Most funds, exchange-traded funds and open-end mutual

01:13 funds, the usual kind of fund, they always trade at net asset value, the value of their stocks that

01:18 they own or bonds that they own. But these closed ends are kind of weird, right? I mean, they could

01:23 trade anywhere, right? Why? What happens? That's exactly right, Bill. I think the main

01:29 difference is if you think of an open-end mutual fund, let's say we're talking about a big growth

01:34 fund that buys shares in Apple and Microsoft, it's very easy for the portfolio manager to deal with

01:41 the inflows and the outflows by basically selling and buying depending on the flows.

01:48 There's really not a lot of slippage. It's easy for the portfolio manager.

01:52 The difficulty becomes though, if it's a mutual fund that's doing something more esoteric,

01:58 emerging markets, as you can think of any type of crisis, we've seen many of them in our lifetimes,

02:04 when everybody decides to sell at the same time, the portfolio manager is inundated with redemptions

02:11 and they have to go ahead and sell all their positions out, which that's not really great

02:16 for really anybody. It's bad for the shareholders that want to stay in the fund and it's bad for

02:22 the portfolio manager because they have to sell things in the market. And the nice thing about,

02:28 and really how close-end funds started was they were meant to be for emerging markets and

02:34 things that are holdings that are a little bit less liquid. So you can think of it, instead of,

02:40 if you want to get out of a close-end fund, you can get out on an exchange. So there's always going

02:47 to be a bid and an offer. There's always going to be somebody on the other side of the trade.

02:50 In a mutual fund, if the portfolio is illiquid and the portfolio manager has to get out of shares,

02:58 it's really difficult. It may move the price quite a bit in stocks. So I think what you think

03:04 about is a close-end fund is really providing liquidity for investors and it doesn't take

03:10 anything away from the portfolio manager that can continue to hold the position. So I think that's

03:15 really the big difference is that you're affording the buyer of a close-end fund liquidity. And then

03:21 that leads into the idea of trading at a premium or a discount to net asset value.

03:25 I see. So when I get in or out of a closed-end, I'm really buying and selling secondhand goods.

03:32 And that means that depending on supply and demand, the price that I get or the price that I

03:39 pay could be way out of the baseline. It could be way away from the net asset value. Can you give

03:45 one or two extreme examples of a fund trading at way more than the liquidating value of its

03:52 portfolio or a fund trading at way less? There's many examples. In fact, if you think about it,

03:58 the idea that a close-end fund can trade at a premium or a discount gives you a sense that

04:05 not always is the price equal to net asset value. In an ETF, we do often have most of the times,

04:13 there's a mechanism, an arbitrage mechanism that keeps the net asset value and the price

04:18 almost the same. In a mutual fund, as we mentioned, you're getting in and out at the net

04:25 asset value. So by definition, the price equals the net asset value. Your example, Bill, is exactly

04:31 right. So there's many different funds that trade at discounts. In fact, many different bond funds

04:38 at the current moment are trading at big discounts. Many equity funds are trading at discounts.

04:43 One of the examples is Central Securities Corporation. This is a fund that's trading

04:48 at a 20% discount to their net asset value. Well, that's also an interesting... By the way,

04:55 I might think of that as being a good stock to own. Maybe, maybe not. Maybe you're not offering

04:59 an opinion on it. But if our audience looks that up, they're going to find that 20% discount. And

05:04 if they look deeper, they'll see one of the great reasons for owning a closed-end, because this

05:10 thing has a big position and a very illiquid stock. The stock that it owns is Plymouth Rock Insurance.

05:17 And boy, that thing is on the balance sheet at a low number, but it's probably worth a whole lot

05:24 more. However, if this were an open-end fund and the manager had to sell all, he couldn't sell

05:31 this thing. It's privately held. It's worth a lot of money, but he can't dump it. So that might be

05:37 a very interesting example of an illiquid stock in a closed-end fund. Now, Central Securities is

05:45 liquid, because if I own 100 shares of that and I go and trade... What does it trade? On the big board?

05:50 That's right. All right. So if I want to put in a sale order, 100 shares of Central Securities,

05:55 no problem. A buy order, no problem. There's plenty of liquidity in Central Securities.

06:01 And if I'm buying, yeah, it's pretty cheap. What's an example of a fund trading at a premium?

06:07 You know, it's got a hundred bucks worth of securities per share, but you have to pay 110

06:13 for it or more. What's an example? So premium funds are out there. And usually people buy the funds

06:20 because it offers something that they're really keen on. And specifically, it's usually funds

06:28 that are esoteric. I think as you can recall, there was a few funds that were investing in

06:34 Bitcoin and they were trading at premiums for quite a while because it was hard for the general

06:41 public to access Bitcoin. So they were buying it in the closed-end fund format. And this is

06:47 GBTC as one example. Now that fund trades at a discount, but it did trade at a premium.

06:52 Another example of a fund at a premium is the Gabality Utility Trust, GUT. And that fund is

07:00 trading at a premium. It's been as high as a hundred percent premium. And it trades at a

07:06 premium because the idea that investors can hold that fund and then still get quite a big dividend.

07:13 And many times the distribution is actually a return of capital. It's a little bit more

07:18 esoteric, but basically it's a very, very high distribution rate. That very high distribution

07:23 rate really gets investors very interested to hold it. And it pushes the price to a higher premium.

07:30 The closed-end fund industry is about $210 billion. I think it's one of the things where

07:37 closed-end funds actually outdate mutual funds. They predate them and they're originally created

07:44 to invest in emerging markets. One of the earliest funds was in the late 1800s and it was a Dutch

07:53 fund. It was a Dutch closed-end fund. And one of the emerging market positions it held was the

07:58 United States of America. Well, I guess I can't roll the clock back to 1890 and buy that great

08:04 stock. But the one you mentioned earlier, central securities, didn't that open like two weeks before

08:09 the great crash of 1929? Bad timing, right? Exactly. Well, it could have been really good

08:15 timing if you think about it. If they launched it and raised all the capital a week or two before

08:20 the crash, they can go out and invest in everything that's extremely cheap. But I think one of the

08:26 things that, as you mentioned, the entire net assets of the closed-end fund industry, it's not

08:32 even a small fraction of the cash that Apple has on its balance sheet. Even though one in eight

08:39 stocks that trades on the big board is a closed-end fund. It's astounding. One in eight. Wow.

08:45 Yeah. It's about one in eight. And they don't trade a lot. A lot of times investors, they buy

08:52 and hold them. They're holding them for yield and they're longer term. They're actively managed

08:59 funds. And they're just not traded as much. And given the fact that they're closed,

09:06 they don't really grow like ETFs are closed that are open in funds. So the fact that they don't

09:11 grow and they're also required to pay out almost all of their income. So you can think of it,

09:18 everything's getting paid out in the form of the dividend. So it's really hard for them to grow. So

09:22 for many, many years, the industry's actually not grown at all.

09:26 I see. Well, that maybe plays into your hands because you're trying to find hidden bargains

09:31 and you're avoiding, of course, all of the overpriced things that cost twice as much as

09:36 they should. So discounts today, what are the average and how does that compare with five years

09:42 ago or a hundred years ago or 10 years ago? The average discount of all the industry right now

09:48 is about 9%. So you can think about 100 cents, you're paying 90 cents on the dollar for an

09:55 average closed end fund. And different funds have different discounts. And this has been

10:00 ever since the beginning of time. Whenever you have a very in vogue or a very hot sector,

10:07 tends to be a lot more demand, pushes the price to a premium. And then conversely,

10:12 whenever you have something that's out of favor, like right now, fixed income is almost a dirty

10:19 word. As you know, we're about to hit 5% in the 10 year. A lot of investors are quite apprehensive

10:24 to own anything that says fixed income in it. Even though the funny thing is, is that most of

10:31 the fixed income funds, the closed end funds that is, they're not really fixed income, they're

10:35 actually floating rate. So it's actually really, in many cases, a very good bargain to hold these

10:40 closed end funds at a discount. I see. Well, you have to be careful. You have to look at a lot of

10:46 things. You look at discounts, you look at premiums, you look at yields, you probably look

10:50 at liquidity. Maybe you don't want to be in a very illiquid closed end fund. Do you ever look

10:55 at the management cost of a fund? I mean, maybe some of those discounts are deserved because

11:01 the managers are pulling down big fees for doing not much, not much good for me.

11:06 That's right. That's exactly it, Bill. So many times, so there's about 20 different factors

11:12 that we look at. We really, we take apart the fund and we deeply dive into the nuts and bolts

11:20 of where, how is the manager? Because remember, these closed end funds are managed by portfolio

11:27 managers, just like an open end fund. Conversely, an ETF is a passive, right? So it's just basically

11:33 a formula. In this case, there's real people behind it and they're making real investment

11:38 decisions. So you really want to pay particular attention to who the pilots of the fund,

11:43 who's flying the aircraft, so to speak. And then you want to, just like an airplane example,

11:49 you want to think about what's the cost of the fuel on board? What is it carrying? What's the

11:54 range of the aircraft? What's the price to get on the aircraft? All these things matter.

12:00 And I think at the end of the day, there's about 20 variables that I mentioned.

12:03 Expense ratio is very important. As you mentioned in municipal bond funds, if your expense ratio is

12:10 four or 5%, I mean, that's quite a wallop of a fee. You can go out and buy a Vanguard or a BlackRock

12:17 ETF or low cost, no load mutual fund and pay very, very little expense ratio.

12:27 And so it really depends. Now, many times the discount can warrant and actually be quite

12:33 justified because it's such an extreme level. But if you're talking a 10 or 15% discount,

12:39 it's not really, it's not warranted at the moment. Well, hopefully we'll find some way to make a lot

12:44 of money in this interesting and complicated sector. More research is needed, I think we'll

12:50 have to tell our audience. They want to buy a fund, they should look at a lot of different

12:54 angles before they put in the buy order. Thank you very much, Eric. This has been a fascinating

12:59 discussion and I hope the field gets a little bigger because that would give me more opportunities

13:03 to make money. Actually, thank you very much, Bill. We like it just the way it is because

13:08 it really favors the smaller investor that's willing to spend the time and the due diligence

13:16 to kind of find those opportunities. But it is a really interesting field. We specialized in it

13:24 for over 40 years. So we like it just the way it is.

13:28 [BLANK_AUDIO]

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