Closed-End Funds vs. ETFs: Are You Missing Out On "Secret" Profits From Emerging Markets?

by Karim Rahemtulla

Closed-End Funds vs. ETFs: Are You Missing Out On "Secret" Profits From Emerging Markets?

by Karim Rahemtulla, Advisory Panelist

Tuesday, March 16, 2010: Issue #1217

As I noted in my column last week, the explosion in popularity of ETFs and ultra ETFs has changed the way many investors gain broad diversification.

An ETF...

  • Gives you exposure to multiple assets through just one investment.
  • Contains a basket of stocks and trades in real-time on major exchanges, based on the value of the underlying assets in the basket.
  • Offers low management fees.

By contrast, closed-end funds...

  • Are actively managed. This means they have portfolio managers who trade the assets within the funds as they see fit.
  • Charge higher fees.
  • Have their value determined by the underlying value of the holdings - just like ETFs. But the price you pay is based on factors like the liquidity of the various investments... when the companies don't trade in the United States (emerging market closed-end funds)... the talent of the portfolio manager... plus currency and political considerations. This means you either pay a premium or discount on the fund's Net Asset Value (NAV).

In short, many investors have found that investing in ETFs is easier, cheaper and more efficient than closed-end funds. They're more transparent.

Great, right?

Kind of. You see, ETFs don't offer the "secret" profit angle that that closed-end funds do - especially from emerging markets...

Three Ways to Buy Foreign Stocks

I began my analyst career as the Research Director at one of the largest emerging markets newsletters. It meant that I traveled frequently to places like China, India, Turkey, Indonesia, Malaysia, South America, etc., to conduct due diligence on the countries and companies within them.

At the time, there were only three ways to invest in emerging market companies...

  1. Buy shares in foreign company ADRs (American Depositary Receipts). But they were only available on really big companies and were very limited in availability.
  2. Buy companies' shares on local exchanges. But that was hard to do, as there were only one or two U.S. brokers who could do it for individual investors and the commissions were very high.
  3. Through via open-end funds or closed-end funds. This was usually the route that most investors took.

Today, however, many investors have switched to buying individual shares because of the easier access to local markets and proliferation of ADRs. And ETFs and open-end mutual funds still remain popular.

Closed-end funds are ignored, though. And that's a mistake...

Why You Should Invest In Closed-End Funds - Plus the Best Time to Do So

It's through closed-end funds that you can bank "secret" profits that very few people know about or understand. Especially when markets are volatile to the downside.

Here's how closed-end funds work:

  • They trade like stocks. When the market is open, people buy and sell these funds based on two factors - supply and demand and the underlying NAV. Sometimes, the fund's price has no relation to the actual NAV of the fund.
  • Unlike regular mutual funds, which are priced after the closing bell each day, based on the value of holdings, closed-end funds are priced based on what buyers and sellers are willing to pay for the shares. Because of this "investor pricing," closed-end funds give you a huge opportunity to make money from a secret spread. The secret spread is the difference between the actual NAV and the price at which the fund is trading.

When a fund's share price is trading for more than the NAV, it's trading at a premium. When the price is less than the NAV, it's trading at a discount.

In my experience, the best time to buy a closed-end fund - especially those that trade emerging markets shares - is when the share price trades at a discount of 20% or more to NAV.

What that means is that you're buying $1 worth of assets for $0.80. Of course, you must be sure that you're investing in something that can bounce back. That's why I'd rather trade the closed-end funds of emerging markets.

So next time you see an emerging markets selloff, look to closed-end funds to boost your returns.

Good investing,

Karim Rahemtulla

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