FREE NEWSLETTER

The Price Isn’t Right

Steve Abramowitz

YOU’VE PROBABLY HAD the same experience I’ve had when shopping for clothes. Spring’s in the air—a great time to take advantage of the local clothing store’s annual winter clearance sale. You buy that Ralph Lauren cashmere sweater at 20% off and jaunt home basking in glory. But the next day, while out for a walk, you peek at the store’s window display and see the same sweater, but now marked down 30%. You return home bemoaning your impulsivity.

Welcome to the befuddling world of closed-end funds.

The proclamation that closed-end funds can be bought for a 10% or bigger discount is no less tempting than that handsome sweater. But it’s just a come-on. How so? All closed-end funds have two prices. There’s the market price at which you can buy and sell—and then there’s the net asset value, which is the value of the fund’s holdings expressed on a per-share basis.

The good news: The market price might be below the net asset value, allowing you to buy the fund at a discount. The bad news: Unlike a regular mutual fund, there’s no guarantee you can sell your closed-end fund for its net asset value. Instead, you must trade at the market price, which bounces around with the mood of the market.

Still, if a closed-end fund owns stocks you’d like to have in your portfolio, it might be a good candidate for purchase, but only if the current discount is greater than the usual discount over, say, the past five years. Timing—a dicey dalliance in its own right—holds the key. A closed-end fund’s discount is typically largest when its stock portfolio is most out-of-favor.

To see how much premiums and discounts can fluctuate, let’s look at BlackRock Health Sciences Term Trust (symbol: BMEZ), a closed-end fund focused on smaller health and biotechnology names.

The BlackRock fund’s discount is currently almost 15%, versus a 9% average over the fund’s history, which means the fund is attractive, though not as big a bargain as it has been. Back in December, before the recent health tech revival, the discount was a whopping 18%, perhaps an opportunity for a high-wire deep value investor, but a catastrophe if you were out of Xanax or needed to sell.

Indeed, in 2022, the BlackRock fund’s portfolio declined 23% but its market price plunged 33%. That plunge might seem especially surprising given that the fund sells options on about a fourth of its portfolio, a strategy designed to limit losses.

Providers of closed-end funds are quick to glorify their very high distribution rates, often mistakenly referring to them as dividends. Annual distributions can exceed 10% of a fund’s share price, are usually paid monthly, and are artificially made to appear smooth and predictable, a marketing ploy to attract retirees and other income investors. How can the distribution rates be so high? It’s flimflam.

Here’s how it works. Closed-end fund distributions are paid from three main sources: dividends, capital gains and a category aptly named “return of capital.” If Vanguard Group’s health care fund (VGHCX) yields less than 1% and Fidelity’s biotechnology offering (FBIOX) hardly anything at all, how can the BlackRock fund throw off about 10%? It can’t, at least not without some skullduggery. When dividends and capital gains meet expectations, all is well and the BlackRock fund’s distribution cruises at almost 1% a month without robbing the net asset value of your investment.

But what if the BlackRock fund’s dividends and market gains fall short of the desired distribution? How can the fund managers possibly make good on their effort to maintain a high monthly payout when we know that the average dividend of smaller health growth stocks is about 1% a year? The standard fix for the small but devoted closed-end fund community is simple but hardly kosher.

Like many closed-end funds, BlackRock Health Sciences plugs some of the leak by reaching into your own money as part of the “distribution,” a practice known as destructive return of capital. What if the distribution rate eventually proves unsustainable? A fund will cut its distribution. This precipitates pandemonium in the fund’s price as all those hoodwinked income investors bail.

Consider the payout for BlackRock Health Sciences over 2023’s first four months. Each month’s distribution was 14½ cents a share, so we’ve met the constancy criterion. According to Morningstar, January’s distribution was paid from short-term capital gains, another promise kept. But the picture turns grim in February, March and April, when the 14½-cent distributions were merely a return of shareholders’ own money. There’s your ill-gotten twist on the proverbial money back guarantee.

The litany of closed-end fund sins and drawbacks doesn’t stop with return of capital. Expenses for the Vanguard and Fidelity funds are 0.3% and 0.72%, respectively, whereas the comparable figure for the BlackRock fund is 1.32%. Even that is low compared to many closed-end funds, which are vestiges of the high-fee fund era of yesteryear. And remember, unlike mutual funds which are transacted at their closing net asset value, closed-end funds are bought and sold like stocks during the trading day. Because most closed-end funds trade on light volume, they’re subject to uncommonly large bid-ask spreads.

But why worry about such nonsense? Today, there’s no need to—thanks to the flourishing worlds of index-mutual funds and exchange-traded index funds.

Steve Abramowitz is a psychologist in Sacramento, California. Earlier in his career, Steve was a university professor, including serving as research director for the psychiatry department at the University of California, Davis. He also ran his own investment advisory firm. Check out Steve’s earlier articles.

Want to receive our weekly newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
17 Comments
Newest
Oldest Most Voted
Inline Feedbacks
View all comments

Free Newsletter

SHARE