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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.

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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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Jim Burrows
Jim Burrows
1 month ago

Burton Malkiel discusses a similar approach in his book, A Random Walk Down Wall Street.

mjflack
mjflack
1 month ago
Reply to  Jim Burrows

Jim Burrows, thanks for noticing this. Malkiel mentions that “Think of a $100 savings account paying 5 percent interest. You deposit $100 and earn $5 interest each year. Now suppose you could buy a savings account at a 50 percent discount . . . You would still get $5 interest, but since you only paid $50 for the account, your rate of return is 10 percent (5/50).”

David John
David John
1 month ago

Thoughtful analysis and always great to buy something at a discount. One data point you need to consider is the unrealized gains in the fund. Here is the semi annual report. Total assets $1.1 bn. Unrealized gain $611 million. If the fund were to liquidate and sell everything, taxable investors would see a tax bill of say 20% on the $611 or about $120 million. That is about 10% of the fund- most of your discount.

So best to own this in an IRA to actually be buying at a discount.

mjflack
mjflack
1 month ago
Reply to  David John

David John, Holding in an IRA would be preferred but . . . the chance of CET liquidating is quite small. If it does, you still come out way ahead and the true discount of CET (due to its Plymouth Rock investment) is closer to 20%. Thanks for your comments.

mjflack
mjflack
1 month ago
Reply to  David John

David John, a valid concern if the fund liquidates. If they don’t, I’ll continue to get paid a dividend stream that I purchased at a >13% discount.

Philip Stein
Philip Stein
1 month ago

Mike, help me out here. As you mention below, if CET has outperformed the S&P 500 over the last 25 years, why is it trading at a discount? With that kind of performance, I would have expected it to trade at a premium.

mjflack
mjflack
1 month ago
Reply to  Philip Stein

Philip Stein, that’s a valid point. As the Gabelli Utility Trust (GUT) trades at an 88% premium, the reasons why closed end funds trade at premium or discount may be unknowable.

Nick M
Nick M
1 month ago

If you’re looking for an asset with an historically massive discount from its all time high, you should check out the current spot price of tulips.

mjflack
mjflack
1 month ago
Reply to  Nick M

Nick M, you go with the tulips, I’ll go with the tulip bulbs.

David Shapiro
David Shapiro
1 month ago

Thanks for taking on the conventional wisdom–but I need some more convincing! It seems to me the main reason to buy an investment asset like a mutual fund at a discount is if you have reason to expect the discount to net asset value to narrow in the future, so you can sell it at a higher price. Yes I’d sell you my 85 cents for a dollar today, but not if I can only sell that dollar for 85 cents in the future (selling for money is all you can do with a mutual fund investment)! If the discount remains the same over time, then your gain when you eventually sell will be just (1) the gain in value of the underlying stocks plus (2) the yield. The gain in value of the underlying stocks would be expected to be the same gain as a broad index fund but subject to the risk of underperforming the index due to active management (poor) decisions and expense. The yield of 5% is higher than a pure stock index fund but has to be the result of increased risk, if you believe the efficient market hypothesis. Plus you have taken on the added risk that the discount will have increased at the time you sell the investment, which raises the question of why there is a discount in the first place. Why doesn’t the current “discounted” price reflect all current marketplace knowledge (including the 5% yield), thus you are betting that you know better than the market? Seems no different than owning an individual stock that you think is undervalued. Please explain why my reasoning is wrong, thanks!

Last edited 1 month ago by David Shapiro
mjflack
mjflack
1 month ago
Reply to  David Shapiro

David Shapiro, imagine you thought IBM was good investment. Would you rather pay the full price for a share or 85%? Even if the discount of 15% never narrowed you would still want to buy the discounted shares. Why? Because you would be receiving IBM’s dividend stream at a 15% discount.

Christopher Viscomi
Christopher Viscomi
1 month ago

Thank you for a thoughtful and illuminating viewpoint. I have one question about timing (I know, not thought of highly on H.D.). In looking at the discount history of CET, it looks like the current discount is a bit low now compared to the range of discounts seen with this closed end fund. Does that suggest anything to you as you considered this purchase?
Many thanks again!

mjflack
mjflack
1 month ago

Christopher Viscomi, I like the way you think! There is something to be said for investing in CET when its discount trades above its historic discount. I bought shares recently based solely on the YTD drop in the general market. Though honestly since this is a forward lookin’ investment I’m not sure using historic discount rates as a guide is valid.

Last edited 1 month ago by mjflack
jay5914
jay5914
1 month ago

I wish you luck with your choice of CET. Maybe it will outperform the sp500 in the future, maybe it won’t. How is this any different than “picking” an individual stock which you deem undervalued or picking the next active mutual fund manager due to outperform? I don’t see much difference. Index funds are popular for very good reasons: low fees, diversification, tax efficiency, long term outperformance. I tell any friends/family who ask that portfolio allocation is key and to index 100%. For those who can’t resist the temptation to “outperform” the index, I say use 10-15% of your investable funds to make your “picks”. I also tell them to do themselves a favor and do an honest look back after 5, 10 years to see if they “outperformed”. The statistics, which we have all seen before, show that outperformance vs the index is very difficult to achieve.

mjflack
mjflack
1 month ago
Reply to  jay5914

jay590000, thanks for the well wishes!! If I offered you $1 for $0.85 would you take it? Well, that’s what CET offers me . . . and I have taken it. And that is very different than picking individual stocks. If someone offered you shares of an index fund that trades at a 15% discount, would you buy some or hold out for shares that trade at a 0% discount?

I have an even better idea for those who can’t resist the temptation to “outperform” the index, I say use 10-15% of your investable funds to buy shares in a low-cost closed-end mutual fund that trades at a 15% discount.

Nick M
Nick M
1 month ago
Reply to  mjflack

Let’s test that theory shall we? Go out today and sell one share. Okay, now did you receive $1 or $0.85 for that share? If you received $1 you’re a genius. If you received $0.85 you’re clearly just gambling.

mjflack
mjflack
1 month ago
Reply to  Nick M

Nick M, you must remember that I’m also buying a dividend stream at 85% discount.

jay5914
jay5914
1 month ago
Reply to  mjflack

If the 15% discount was a sure thing, sure, I would take it. However, if it was a sure thing it wouldn’t exist. 
We can agree that an indexer who chooses to actively manage a small portion of his/her portfolio might consider closed end funds just as he might consider individual stocks, commodities, hedge funds, cryptocurrency, etc. 

mjflack
mjflack
1 month ago
Reply to  jay5914

jay590000, if you are looking for sure thing, then I think you are at the wrong website.

Kevin Thompson
Kevin Thompson
1 month ago

The funny thing about the index, you cannot buy the index. It is actually impossible. You can purchase things that are similar, but owning an actual index is not possible due to the fact the index doesn’t have trading cost, taxes, manager methodology, etc. Vanguard, blackrock, fidelity are providing you a version of the index, with a fee, although fidelity and some funds may present them with no cost. You still, unfortunately have to pay taxes on those shares, so expecting the same returns as the index is a fallacy.

Funds beating the index take on additional beta to beat that index, so it is safe to say, if you want to beat the index you would actually need to take on more risk than the index.

just food for thought.

mjflack
mjflack
1 month ago
Reply to  Kevin Thompson

Kevin Thompson, don’t necessarily agree with your first paragraph – it seems argumentative. Or your second one: generally you need to take on more risk to beat the index, but not always, as some investments can beat the index with less beta (though you never know until after the fact).

mytimetotravel
mytimetotravel
1 month ago

You haven’t allowed for the extra time and effort required to do the research to understand and then choose a closed end fund. Most investors are amateurs and index funds are a great choice for amateurs.

mjflack
mjflack
1 month ago
Reply to  mytimetotravel

mytimetotravel, this article now allows you to take advantage of my time and effort in choosing the correct closed-end fund. You’re welcome!

parkslope
parkslope
1 month ago

Thanks for your explanation of clos-end funds.
Regarding your interest in debating closed-end funds versus index funds I would note that you didn’t present any evidence that closed-end funds with large discounts outperform the S&P.

mjflack
mjflack
1 month ago
Reply to  parkslope

parkslope, As mentioned in my article I purposely did not include any reference to past performance, as I am using forward looking analysis. But since you asked . . . through Dec 31, 2021, over the last 25 years, CET has outperformed the S&P Index by 88 basis points/year.

Last edited 1 month ago by mjflack
parkslope
parkslope
1 month ago
Reply to  mjflack

As you noted, past performance is problematic for choosing actively managed mutual funds. However, if we ignore past performance, then your interest in a Socratic dialogue appears to be one of the relative merits of closed-end funds with large discounts versus index funds. While it is logical that large discounts are preferable to small discounts, this really doesn’t get at the issue of the relative merits of closed-end funds versus index funds. Perhaps you could clarify how we can have a meaningful Socratic debate that ignores past performance.

mjflack
mjflack
1 month ago
Reply to  parkslope

parkslope, so in order to have a meaningful Socratic dialectic I have to mention “past performance?” Who made you Socrates?

M Plate
M Plate
1 month ago

I agree with you 100%. I admire your courage. Normally a nice group here, but I’d hate to run into them in dark alley after “disrespecting” the almighty index fund.

mjflack
mjflack
1 month ago
Reply to  M Plate

M Plate, appreciate the warning, I’ll be careful.

Michael1
Michael1
1 month ago

Thanks for this article. I know very little about closed end funds. FWIW, just found this rather dated one on Morningstar as well.

https://www.morningstar.com/articles/3549/what-are-closed-end-funds

mjflack
mjflack
1 month ago
Reply to  Michael1

Michael1, thanks for your comments and the link.

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