With a market run-up, it could pay for clients to consider the handful of closed-end stock funds selling at bargain-basement prices.

The average closed-end stock fund's market price trades at a 10% discount to its net asset value. But the average closed-end fund's net asset value, thanks to the stock market's rise so far this year, was up 12% as of mid-February, according to Thomas J. Herzfeld Advisors Inc., Miami. "With equity prices showing strength of late, now is a good time to invest," suggests the firm's chief investment officer, Cecilia Gondor.   

Closed-end mutual funds issue a fixed number of shares that trade on a stock exchange. But unlike traditional mutual funds, which are traded at net asset value, a closed-end fund's share price fluctuates, based on market supply and demand. As a result, closed-end funds can trade at discounts or premiums to their net asset values.
Research over the past two decades has consistently shown that it can be profitable to invest in a closed-end fund selling at a discount when the discount to the fund's net asset value narrows at least 3 percentage points. Portfolios using this tactic have outperformed the S&P 500 over the long term.

But this may require a long-term trading strategy. Over the short term, owning closed-end funds at a discount can prove risky. Closed-end fund stock market prices are 64% more volatile than their net asset values, according to a study by Jeffrey Pontiff, a Boston University finance professor, published in The American Economic Review, Pittsburgh, in 1997.

Although that study is more than a decade old, the more recent market downturn of 2008 seemed to substantiate Pontiff's assertion that closed-end stock prices are more volatile than their net asset values. That year, the average closed-end fund stock price lost 39% compared with a 37% loss on the S&P 500, according to Morningstar Inc., Chicago.

Gondor says advisors must be selective when buying closed-end stock funds. Only a few have appealing discounts. These funds often are overlooked because of low yields. Most of the money has been pouring into closed-end bond funds that pay high yields because the portfolios are leveraged. Bond closed-end funds, however, are overvalued and poised to decline when interest rates rise, she warns.

Stock funds with little or no distributions, including those that make only annual payouts of net realized capital gains, continue to trade at the widest discount levels of all categories, she adds.

"There are signs that this disparity in valuations between equity funds and income funds may be starting to change," she says. "Over the past year, we documented more distribution increases than decreases among equity and specialized equity funds while recent trends show equities, in general, are returning to favor."

Meanwhile, Gondor says taxable closed-end bond funds are slashing distributions. Tax-free municipal bond funds may cut payouts in the future because the funds are paying out more to shareholders than they are earning in interest and capital gains.

"We sold municipal [closed-end] funds last year and lightened our holdings in other income-oriented funds over the past month," she says. The objective: to sell into the "January effect"-a seasonal narrowing of discounts after a period of widening created by year-end tax-selling pressures.