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THE MALKIEL STEP
As readers of previous editions know, I like to buy shares in
a special type of investment fund called a closed-end fund
(officially, a closed-end investment company) when they are
available at attractive discounts. Closed-end funds differ from
open-end mutual funds (the kind discussed in the previous
section) in that they neither issue nor redeem shares after the
initial offering. To buy or sell shares, you have to go to a
broker.
The price of the shares depends on what other investors
are willing to pay for them; however, unlike shares in open-
end funds or in ETFs, this price is not necessarily related to
net asset value. Thus, a closed-end fund can sell at a premium
above or at a discount from its net asset value. During much
of the 1970s and at the start of the 1980s, these funds were
selling at substantial discounts from their net asset value.
Closed-end funds hire professional managers, and their
expenses are no higher than those of ordinary mutual funds.
So for those who believe in professional investment
management, here was a way to buy it at a discount, and I
told my readers so.
A small proportion of the discounts on closed-end funds
could be explained by rational considerations. Some funds had
a substantial amount of unrealized capital gains in their
portfolios that could affect the timing of an individual’s tax
liabilities. Other funds had substantial holdings of “letter
stock,” the sale of which was restricted and whose market
prices might not have been accurate reflections of their true
value. But these considerations could at best explain only a
minor proportion of the discounts that ran as high as 40
percent during the late 1970s. My own explanation for the
discounts ran in terms of an unexploited market inefficiency,
and I urged investors to take full advantage of the
opportunity for as long as it lasted.
The beauty of buying these highly discounted closed-end
funds was that, even if the discounts remained at high levels,
investors would still reap extraordinary rewards from their
purchase. If you could buy shares at a 25 percent discount,
you would have $4 of asset value on which dividends could
be earned for every $3 you invested. So even if the funds just
equaled the market return, as believers in the random walk
would expect, you would beat the averages.
It was like having a $100 savings account paying 5 percent
interest. You deposit $100 and earn $5 interest each year.
Only this savings account could be bought at a 25 percent
discount—in other words, for $75. You still got $5 interest (5
percent of $100), but because you paid only $75 for the
account, your rate of return was 6.67 percent (5 ÷ 75). Note
that this increase in yield was in no way predicated on the
discount narrowing. Even if you got only $75 back when you
cashed in, you would still have received a big bonus in extra
returns while holding the account. The discount on closed-end
funds provided a similar bonus. You got your share of
dividends from $1 worth of assets, even though you paid
only 75 cents.
The strategy worked even better than expected. Discounts
have narrowed significantly on U.S. closed-end funds.
Although the publicity given closed-end funds in my books
may have helped to close the discounts, I think the
fundamental reason for the narrowing is that our capital
markets are reasonably efficient. The market may misvalue
assets from time to time, creating temporary inefficiencies.
But if there is truly some area of pricing inefficiency that can
be discovered by the market and dependably exploited, then
value-seeking investors will take advantage of these
opportunities and thereby eliminate them. Pricing
irregularities may well exist and even persist for periods of
time, but the financial laws of gravity will eventually take
hold and true value will out.
With their discounts for the most part dried up at the time
this edition goes to press, most domestic U.S. closed-end
funds are no longer an especially attractive investment
opportunity.
*
But discounts exist for some international
funds and funds investing in emerging markets. Diversified
portfolios of emerging-market closed-end funds selling at
discounts are a viable—and probably a preferable—
alternative to an emerging-market index fund. When discounts
of 10 percent or more exist, it is time to open your wallet to
closed-end funds. The table below lists a few closed-end
emerging market funds with their discounts as of mid-2010.
Check the discounts when you are ready to invest to
determine whether they are greater than 10 percent.
Discounts do vary from week to week.
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