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In Praise of Active

Michael Flack

I REALIZE THAT MOST HumbleDollar readers share a similar investment philosophy. They believe in market efficiency, keeping expenses low and holding down taxes, all of which leads them to genuflect at the altar of the all-mighty index fund.

Words and phrases such as Robinhood, bitcoin and active management don’t appear often on this site and, when they do, they’re mentioned with disdain. While this may be a good thing in the main, we should test our beliefs occasionally, if only as part of a Socratic dialectic.

A Socratic dialectic, according to that repository of all human knowledge, Wikipedia, “is a discourse between two or more people holding different points of view about a subject but wishing to establish the truth through reasoned argumentation.”

I’m putting forward that “different point of view” today. Otherwise, how can we know the truth?

This process reminds me of the Cuban missile crisis, when the Soviet Union deployed ballistic missiles in Cuba in 1962. Most of President John F. Kennedy’s advisors recommended a hardline approach, favoring an air strike on the island. His ambassador to the United Nations, Adlai Stevenson, advocated for compromise. Stevenson was upbraided by the hardliners, who were “outraged and shrill,” according to historians.

“You have to admire Adlai,” Kennedy said to his brother Robert, the attorney general, afterward. “He sticks to his position even when everyone is jumping on him.”

The compromise Stevenson advocated did resolve the crisis peacefully. The Soviets withdrew their missiles from Cuba and, in exchange, the U.S. agreed to remove its missiles from Turkey—secretly.

In the spirit of both Socrates and Stevenson, I advocate actively managed mutual funds for their ability to offer slightly superior returns. “Prepare to defend yourself,” I hear you say. I will.

I don’t advocate active mutual funds based on past performance. Almost all articles that recommend specific active funds are based on their historical returns. Yet past returns are just that—past.

The performance may be due to luck, to a manager that’s no longer there, or to a manager who will no longer be in charge next week. And I don’t want to hear the words “Warren Buffett.” He doesn’t manage a mutual fund. Rather, he runs an insurance company, at least according to Value Line’s categorization.

Instead, I will advocate for a very specific kind of actively managed fund, the closed-end fund. A closed-end fund issues a fixed number of shares in an initial public offering. Thereafter, its shares can be bought and sold on the market, but no new shares are created and therefore no new money flows into the fund.

A closed-end fund has two prices, a share price and a net asset value, or NAV, which is the value of its portfolio figured on a per-share basis. The fund’s share price might trade at either a premium or a discount to the value of the portfolio. This doesn’t happen with open-end funds, whose shares always trade exactly at NAV.

In other regards, closed-end funds are similar to actively managed open-end funds. You have to pay management for its dubious stock-picking ability. Actively managed open-end fund have an average asset-weighted expense ratio of 0.68%, equal to 68 cents a year for every $100 invested, which makes outperforming the market extraordinarily hard.

Most investors would agree that buying a mutual fund at a discount is better than paying a premium, and that a lower expense ratio is better than a higher one, though it seems some investors think otherwise, such as buyers of Gabelli Utility Trust (symbol: GUT), which trades at an 88% premium, and the Herzfeld Caribbean Basin Fund (CUBA), with its 3.15% net expense ratio.

Theoretically, a large enough discount should more than offset a closed-end fund’s expense ratio, so an investor would, in essence, be paid to own shares in such a fund. I’ll be honest, I’m unsure how big a discount is required, but finding a diversified fund with a larger-than-average discount and a lower-than-average expense ratio seems like a good place to start.

One intriguing option: Central Securities Corporation (CET), which I recently invested in. Central Securities trades at a 13% discount, has a slightly below-average expense ratio of 0.66% and has paid an average 5% yield over the past five years.

Need more discount? Well, almost 22% of the portfolio’s value is invested in shares of privately owned insurer Plymouth Rock Company. The fund determines the value of its Plymouth Rock holdings using a slew of financial ratios, such as price-to-book, price-to-earnings and discounted cash flow. The fund’s managers then discount this price a further 30% to 40% to account “for lack of marketability and control.” All this makes Central’s true discount larger than advertised.

I can understand your general resistance to owning a closed-end fund instead of an index fund. But owning one with a large discount and a reasonable expense ratio, like Central Securities, must be a better option than most other actively managed mutual funds and—dare I suggest?—perhaps even better than owning an index fund.

Sometimes, it can be difficult to believe a new philosophy, no matter how logical or profitable it may be. It reminds me of a scene from the 1983 movie Max Dugan Returns. In it, an old Jason Robards tells a young Matthew Broderick that he should study philosophy in college.

Broderick asks, “Can you make money from philosophy?”

Robards responds, “Yeah, if you have the right one.”

Michael Flack blogs at AfterActionReport.info. He’s a former naval officer and 20-year veteran of the oil and gas industry. Now retired, Mike enjoys traveling, blogging and spreadsheets. Check out his earlier articles.

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