What Is a Closed-End Fund?

Before I explain the strategy of how to trade closed-end funds in the

short term, you need to learn some basic information about closedend

funds. A closed-end fund, unlike a mutual fund, has a fixed number

of shares. These funds trade over the exchange like stocks. One

of the interesting things about closed-end funds is their ability to

trade at a discount or a premium in relation to their true value. This

occurs on a frequent basis due to inefficient market valuation. As

with any stock, at times it is considered undervalued (i.e., worth

more than the price at which it is currently trading). Let me explain

this in the following way. If you could buy a pool of assets (fund)

worth $1 at a 20 percent discount, would you do it? Put another way,

for every 80 cents you spent, you would be buying $1.20 in real

value. The extra 20 cents is the unrealized discount on the asset pool. If you really think about it, buying a closed-end fund and paying

a commission would be far better than buying a no-load mutual

fund. When you buy a no-load fund you are buying a dollar's worth

of assets for a dollar. Closed-end funds offer many advantages over

mutual funds and common stocks. Let's list some other advantages

of closed-end funds.

1. Closed-end funds statistically outperform mutual funds.

This should get the attention of people who try to time

mutual funds.

2. You always know the selling and buying price of a closedend

fund because it trades on the exchange like a stock. If

you think about it, buying a mutual fund is an act of faith,

because you never know what price you are going to pay.

The net asset value (NAV) of a mutual fund is derived after

66 the strategic electronic day trader

the close of the market day. You do not know what price

you paid until the next day.

3. Closed-end funds can be purchased for substantial discounts

from their present value. You can not accomplish

this with mutual funds. In fact, most mutual funds, even noload

mutual funds, have hidden fees associated with them.

Many times, that no-load fund is really costing you

money—you just do not know it.

4. Closed-end funds offer liquidity that simply does not exist

with mutual funds. For example, let us suppose the market

is moving down 570 points based on the Dow and you want

to sell. If you own a mutual fund, you cannot get out until

the end of the day. What if, at the end of the day, the market

is down 870 points? Ouch! When the market fell in October

1987, some people panicked and sold their funds. Even

though the market did come back, several funds took years

to recover a one-day loss. Even the best of funds felt the

effects of Black Monday. Ask Peter Lynch, whose Fidelity

Magellan fund lost one-third of its value that day. Being

able to sell a closed-end fund intraday offers tremendous

advantages over a mutual fund from a risk and money management

viewpoint.

5. Index options can be used to hedge positions of the closedend

funds in a much more cost-effective way.

6. Closed-end funds give you the ability to leverage a position

with the use of margin. This is very advantageous for

traders because closed-end funds, for the most part, while

not extremely volatile, do tend to trend strongly in one

direction or another.

7. Closed-end funds can be sold short. If you think about this,

you can envision ways to hedge your positions that you

might not have thought of before.

8. You can create spread arbitrage by buying one closed-end

fund at a discount and selling another short at a premium.

By now you should realize that these boring funds have some

amazing potential. The information you have received thus far can

be used to improve your trading in various ways. Let us now look at

how you trade closed-end funds.

Before I explain the strategy of how to trade closed-end funds in the

short term, you need to learn some basic information about closedend

funds. A closed-end fund, unlike a mutual fund, has a fixed number

of shares. These funds trade over the exchange like stocks. One

of the interesting things about closed-end funds is their ability to

trade at a discount or a premium in relation to their true value. This

occurs on a frequent basis due to inefficient market valuation. As

with any stock, at times it is considered undervalued (i.e., worth

more than the price at which it is currently trading). Let me explain

this in the following way. If you could buy a pool of assets (fund)

worth $1 at a 20 percent discount, would you do it? Put another way,

for every 80 cents you spent, you would be buying $1.20 in real

value. The extra 20 cents is the unrealized discount on the asset pool. If you really think about it, buying a closed-end fund and paying

a commission would be far better than buying a no-load mutual

fund. When you buy a no-load fund you are buying a dollar's worth

of assets for a dollar. Closed-end funds offer many advantages over

mutual funds and common stocks. Let's list some other advantages

of closed-end funds.

1. Closed-end funds statistically outperform mutual funds.

This should get the attention of people who try to time

mutual funds.

2. You always know the selling and buying price of a closedend

fund because it trades on the exchange like a stock. If

you think about it, buying a mutual fund is an act of faith,

because you never know what price you are going to pay.

The net asset value (NAV) of a mutual fund is derived after

66 the strategic electronic day trader

the close of the market day. You do not know what price

you paid until the next day.

3. Closed-end funds can be purchased for substantial discounts

from their present value. You can not accomplish

this with mutual funds. In fact, most mutual funds, even noload

mutual funds, have hidden fees associated with them.

Many times, that no-load fund is really costing you

money—you just do not know it.

4. Closed-end funds offer liquidity that simply does not exist

with mutual funds. For example, let us suppose the market

is moving down 570 points based on the Dow and you want

to sell. If you own a mutual fund, you cannot get out until

the end of the day. What if, at the end of the day, the market

is down 870 points? Ouch! When the market fell in October

1987, some people panicked and sold their funds. Even

though the market did come back, several funds took years

to recover a one-day loss. Even the best of funds felt the

effects of Black Monday. Ask Peter Lynch, whose Fidelity

Magellan fund lost one-third of its value that day. Being

able to sell a closed-end fund intraday offers tremendous

advantages over a mutual fund from a risk and money management

viewpoint.

5. Index options can be used to hedge positions of the closedend

funds in a much more cost-effective way.

6. Closed-end funds give you the ability to leverage a position

with the use of margin. This is very advantageous for

traders because closed-end funds, for the most part, while

not extremely volatile, do tend to trend strongly in one

direction or another.

7. Closed-end funds can be sold short. If you think about this,

you can envision ways to hedge your positions that you

might not have thought of before.

8. You can create spread arbitrage by buying one closed-end

fund at a discount and selling another short at a premium.

By now you should realize that these boring funds have some

amazing potential. The information you have received thus far can

be used to improve your trading in various ways. Let us now look at

how you trade closed-end funds.