Closed-end funds offer MASSIVE PROFIT opportunities

Investors looking for higher yields in today's low interest rate market might consider closed-end funds, said Marc Rappaport, senior managing director of Alpine Woods Capital Investors LLC, especially those that offer unique strategies that fare better when executed in a closed pool/architecture/framework.

Even though closed-end funds have been around for more than 100 years -- since 1893, according to the Closed-End Fund Association, more than 30 years before the first U.S. mutual fund appeared on the scene -- the average investor is not familiar with them.

Mutual funds are open-end, which means they offer to sell their shares to investors on a continuous basis, and to buy them back, or redeem, when shareholders want to reduce or liquidate their holdings.

Closed-end funds are not offered continuously. They are offered to the public in a manner similar to a stock offering -- through an initial public offering; of course, additional shares can be sold to investors in subsequent offerings. A closed-end fund shareholder cannot present a redemption request to the fund; instead, he has to sell his shares in the market like he would sell a stock.

As a result, the investment manager of a closed-end fund has a distinct advantage over a mutual fund manager.

The closed-end manager works with a fixed pool of capital. In contrast, a mutual fund manager has to react to inflows of cash, when shareholders buy shares, and outflows, when shareholders redeem their shares.

Cash flows can and do affect the manager's decisions over when and what to buy and sell for the portfolio.

"In a time of heightened investor fear, mutual fund redemptions rise and managers are forced to sell portfolio holdings when the managers would rather do just the opposite," Rappaport said.

In contrast, the closed-end fund manager has the advantage of buying and selling based on his convictions, rather than cash flow management. Theoretically, his performance should reflect this management edge.

If you're used to investing in mutual funds, you won't be able to apply the same selection criteria to closed-end funds. There are some major differences.

First, be aware that there are two sets of share prices.

One is net asset value, which is the end-of-day value of all the holdings of the fund, less expenses. Open-end funds and closed-end funds calculate NAV the same way.

The other is market price or market value. Shareholders buy and sell shares of closed-end funds in the stock market throughout the trading day.

Since no one is interposed between the shareholder and the fund -- in contrast to exchange traded mutual funds -- the price at which the closed-end fund trades is set by supply and demand, in the same way that a stock's price is determined. More buyers bid up the price; more sellers drive down the price.

Because of that dynamic, investors buy shares at or below or above net asset value. Remember that net asset value is the underlying value of all the holdings in the fund, representing the value of the fund if it were liquidated or liquidation value.

That means that investors who buy funds at a price below net asset value are buying at a discount.

Now, here's the interesting point for income investors.

If you buy a dividend-paying closed-end fund at a discount from net asset value, your yield will be higher than the fund's yield.

Let me give you an example:

Consider a closed-end fund with a net asset value per share of $10 that you bought for $10 and that the net asset value per share and market price both remained $10 for a year. In real life, the net asset value and market price will fluctuate. Assume that the fund paid a monthly dividend that totaled 30 cents per year for a 3 percent annual dividend yield.

Now assume that you were able to buy the same fund for only $8 a share. You would still receive your 30 cent per share dividend. But your yield would not be 3 percent -- it would be higher, reflecting the lower price you paid for the shares -- in this case, 3.75 percent.

Here's the math: You paid $8 a share for a fund whose net asset value is $10 a share. Your dividend was 30 cents. Thirty cents divided by 8 equals 3.75 percent, which is your annualized distribution yield. The annualized dividend yield reflects the price at which you bought the shares; the yield at net asset value is referred to as the dividend yield.

(Be alert to the fact that some closed-end funds' distributions may also include return of capital, meaning some of YOUR principal may be paid out as part of the distribution -- a subject we'll discuss next week).

On the other hand, if you paid more than net asset value when you bought shares, your annualized distribution yield would be less than 3 percent. If you paid $12 a share, for example, your yield would be only 2.5 percent. Thirty cents divided by 12.

In today's market, you can find funds to buy at discounts as high as 70 percent, turning that same hypothetical 30-cent dividend in my example into a 10 percent yield to the investor -- not to suggest that a prudent investor would buy such as fund solely based on the discount, but you get the idea.

Nonetheless, you can't deny that yield advantages are plentiful for income-conscious investors who buy well-selected closed-end funds at a discount.

Disclosure I am long 10 different Closed End funds