When I went to business school a few years ago (OK, maybe it was more than a few years ago) I remember my finance professor telling the class that it was a mystery why closed end mutual funds traded at a discount. Presumably he was tapped into all the latest academic research about such matters so I assumed it was a mystery. It wasn’t until years later that I came to believe that there really isn’t much of a mystery - and my theory isn’t that complicated, though putting it into words is difficult.

The fundamental difference between a closed end mutual fund and an open end mutual fund is that with an open end mutual fund the fund manager stands ready at all times to exchange shares with an investor at NAV while closed end investors have to make the exchange with each other at whatever price “the market” requires. By itself this difference wouldn’t result in a discount (or a premium) except in some special cases I’ll cover later. However, when you combine this arrangement with the fact that there are costs to managing these portfolios you get an asymmetry. In theory the value of a mutual fund should be equal to the present value of future cash flows, which derive from a combination of the investment returns minus the management expenses. In the case of a closed end fund the value should be discounted to reflect the present value of all future management expenses. In other words, at any point in time the value of the fund should be the present value of the investment returns, which is just the NAV of the portfolio, MINUS the present value of the management expenses. Let’s look at a hypothetical example where a fund distributes all of its investment returns each year, less a 1% management fee. If you discount the 1% fee at a 10% rate that would result in a 10% discount to NAV. Sound about right?

However, for an open end fund the value is just the NAV of the portfolio for two reasons. First, because of management’s guarantee that they will always pay you NAV your shares HAVE to be worth NAV. But there’s another equally valid way to think about the economics of this arrangement. Open end fund investors “pay” for management expenses on an annual basis. When they decide to sell their investment the management fees essentially go away - or at least there is no adjustment for the present value of future management expenses because the next investor who comes along agrees that they will pick up the expenses during the time period they own the shares. The fund manager essentially enforces a “transfer” of responsibility for the management expenses from one investor to the next.

If you buy my explanation then the claim by some of the charlatans out there that closed end funds allow you to buy assets at bargain prices is totally bogus. Would a gallon of milk discounted by 10% be a bargain if 10% of the milk was leaking out? Besides, what kind of bargain is it if your best bet is that you could never sell it at full price anyway?

The real mystery is why closed end funds sometimes trade at enormous discounts, don’t trade at bigger discounts than they do, and why they sometimes even trade at a premium. Usually this comes down to some kind of inefficiency in the market. A few examples:

• The Morgan Stanley China A Fund (CAF) is currently at a 29% discount. As I’ve written before, China A shares are ridiculously inflated because of restrictions placed upon this market by the Chinese government. Consequently, there is no way to arbitrage these inflated prices away and non-Chinese investors do not want to own these shares. So the fund trades at an enormous discount and most certainly does not represent a bargain.
• The First Israel Fund (ISL) is currently at almost a 7% premium but since this fund is one of the few ways to invest in this country it commands a premium.
• During 2006, when Indonesia was really hot, the Indonesia Fund (IF) briefly traded at a premium as high as 40% because there really weren’t good alternatives. Currently, as the country has fallen out of favor, it’s now trading at a 12.4% discount.

However, sometimes the discounts and premiums defy explanation and represent a temporary anomaly that you can profit from. A great example of this that I’ve written about recently is The Spain Fund (SNF), which is currently at an 18.5% premium (it’s come down from a high of 25% and, yes, I’ve racked up profits from that) despite the fact that there is a Spain ETF available that is not at a premium.

The key to earning outsized profits in closed end funds is to understand what’s driving the premiums or discounts and to carefully place bets in those cases where things don’t make sense.

Reprinted with the permission of the American Association of Individual Investors (AAII)

Yield is a term that is used quite often in the investment universe. But it is frequently a source of investor confusion.

The problem is that “yield” has many different meanings, and thus many different implications for investors.

The basic dilemma is that yield may or may not be synonymous with total return-the bottom line for investors.

What It Is

The term “yield,” on its own, is an imprecise term that can mean any number of things-ranging, for instance, from:

• A security’s annual percentage rate of return, to
• The annual income from an investment as a percentage of the price at a particular point in time (for example, the current price).

The more precise definition of yield becomes apparent when a qualifier is used-for instance, dividend yield, current yield, or yield to maturity.

How It Can Be Used

Investors who seek an income component from their investments often look at various yields to indicate which investments will provide a higher amount of their return in the form of annual income payments. Thus, for example, income-seeking investors may prefer a stock with a higher dividend yield than one with a lower dividend yield.

Yields also can be used to indicate the relative risk of different securities. Typically, securities with higher risk must offer higher yields to compensate for the greater risk. Thus, for example, dividend-paying stocks whose firms are having financial troubles will tend to have higher dividend yields than the stocks of financially secure firms, and the bonds of companies with lower credit ratings will have higher current yields than those with higher credit ratings.

How It Can Be Misused

Yield is also sometimes used to indicate a security’s total return. However, it is important for investors to understand the difference between “total return” and most uses of the term “yield.” The bottom line for any investor, for any investment, is total return.

Total return incorporates capital gains and losses, as well as any annual income thrown off by the investment in the form of dividends or interest payments.

Total return is also specific to the individual investor’s particular experience-the purchase price paid for the investment, the holding period, the sales price, and the actual income payments received. Most uses of the term “yield” refer only to the income component and do not include a gain or loss component.

Investors-particularly those individuals who are interested in bonds-sometimes make the mistake of equating quoted yields with total return. However, most quoted bond yields ignore gains or losses in the market value of the bonds, an important component of total return even in a bond holding. Although there is one bond yield measure, as we shall see, that comes close to the total return concept (yield to maturity), it is only an estimate of total return based on assumptions that may or may not apply to the individual investor who has purchased the bond.

Yields for Stock Investors

Dividend Yield

A dividend yield is calculated by dividing the indicated annual dividend (the expected dividend for the next four quarters) by the closing price of the stock. It simply provides the historical annual dividend relative to the current market price in percentage form.

How is it useful?

When compared to other dividend yields measured over the same time period, it tells you the annual income you can expect from this stock relative to other stocks: If you invested today at the current price, you will receive more annual income as a percentage of your original investment from a stock with a higher dividend yield than one with a lower dividend yield. The higher dividend yield also indicates there is a greater risk that dividends may be reduced or not paid in the future. Dividend yield reflects only income, and does not take into consideration gains or losses.

Yields for Bond Investors

Current Yield

A bond’s current yield is calculated by dividing the annual interest payment by the current market price of the bond. Like a dividend yield, it only captures one aspect of total return-the income generated by the investment. It ignores any changes in value from gains or losses.

How is it useful?

The current yield will tell you how much interest income you will receive each year from the bond relative to the price you are paying for the bond, assuming you were purchasing it today at the bond’s current price.

Coupon Yield

A bond’s coupon yield is the simple interest paid by a bond annually as a percentage of maturity value. The coupon yield, also known as the coupon rate, is the annual interest rate established when the bond is issued.

How is it useful?

The coupon yield tells how much income you will receive each year you own the bond, expressed as a percentage of the maturity value of the bond. For example, a bond that is issued with a $1,000 value at maturity and a 4.5% coupon yield will pay $45 in annual interest payments.

This amount is figured as a percentage of the bond’s maturity value and will not change during the lifespan of the bond, regardless of how the price of the bond fluctuates in the secondary markets. This is unlike the bond’s current yield, which fluctuates based on the bond’s current market price.

Yield to Maturity

A bond’s yield to maturity is one yield figure that comes close to a total rate of return concept. However, it makes a number of assumptions. It assumes that the bond is held to maturity, and that all interest payments are reinvested at a rate that is equivalent to the yield to maturity.

Yield to maturity comes close to the total return concept because it takes into account all possible sources of income from a bond, including coupon income, earnings on reinvested income, and capital gains or losses due to the difference between the price paid when the bond was purchased and the return of principal at maturity.

However, it is not a return you will actually receive on a bond, but a rate of return you could expect to receive if you held the bond to maturity and were able to reinvest all income at the yield-to-maturity rate. Your actual return will be determined by a number of factors, including whether you actually do reinvest income, the actual rate of return you receive on any reinvested income, and the difference between the price you paid originally and your selling price (if you sell before it matures) or the value at maturity.

How is it useful?

Yield-to-maturity quotes are useful because they allow you to compare different kinds of bonds-those with dissimilar coupon yields, bonds selling at a discount or premium, and different maturities. For example, how do you compare a 20-year zero-coupon bond that provides no annual income payments but is purchased at a deep discount to its value at maturity, with a 15-year bond that has a 6% coupon yield and is selling at a premium to its maturity value? Looking at the current yield to maturity of the two bonds allows you to make an apples-to-apples comparison of their relative “expected” rates of return. But remember, you would only receive the “expected” rates of return if all of the assumptions held true-you held the bond to maturity, and were able to reinvest all income at the same rate as the yield to maturity.

Yields for Muni Bond Investors

Taxable-Equivalent Yield

The taxable-equivalent yield is the yield on a taxable bond (or taxable bond mutual fund) that would result in the same after-federal-tax yield to an investor as a given tax-exempt bond (or tax-exempt bond mutual fund). It is calculated by dividing the tax-exempt yield by 1.00 minus your marginal federal income tax rate (in decimal form).

How is it useful?

The bottom line for taxable investors is not just total return, but total return after taxes. This yield is useful for high tax bracket investors who may receive a higher aftertax rate of return by investing in tax-exempt municipal bonds rather than taxable bonds. It is used to compare the yield of a tax-free bond to that of a taxable bond in order to see which bond has a higher aftertax yield.

Yields for Mutual Fund Investors

30-Day SEC Yield

A yield quoted by bond mutual funds, the 30-day SEC yield is calculated according to a formula determined by the Securities and Exchange Commission (SEC). It is primarily a snapshot of the interest distributions from the fund over the prior 30 days, with some adjustments.

How is it useful?

The 30-day SEC yield is a standardized yield calculation for bond funds that allows investors to compare the yield performance of one bond fund to another. However, the figure is a reflection of the past 30 days and is not necessarily an indication of future yield.

In addition, the calculation implies the bonds will be held until maturity, and in practice bonds funds tend to trade actively and do not hold bonds to maturity. For this reason, a mutual fund’s income yield (see below) may be a better measure of a bond fund’s income-generating potential.

Yield

A mutual fund’s yield is the per share annual income distribution (which could include interest, dividends and short-term gains net of expenses) made by a mutual fund, divided by its year-ending net asset value, plus any capital gains distributions made during the year.

How is it useful?

This yield is similar to a dividend yield and would be higher for income-oriented stock funds and lower for growth-oriented stock funds.

The figure only reflects income-it is not total return. The yield also may be distorted if the fund reports short-term capital gains as income.

Reprinted with the permission of:

American Association of Individual Investors (AAII)
625 N. Michigan Ave.
Chicago, IL 60611
(800) 428-2244
(312) 280-0170
(312) 280-9883 fax

http://www.aaii.com/

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