Closed-end funds are where the action is.

These funds, which issue a fixed number of shares that trade on the stock exchange, often have a stock price trading at a discount or premium to the net asset value of the securities managed by the investment company, mostly because of inefficiency (when there are more sellers than buyers). But recent trends have caused the price discount against NAV to plunge to record levels, and have forced closed-end managers to come up with a novel solution to narrow the price gap and appease investors: by asking shareholders to convert the funds into more dynamic and efficient exchange-traded portfolios. Such conversions eliminate the problem of closed-end funds selling at these wide discounts.

"Discounts have hit the widest levels in 25 years," says Cecilia Gondor, executive vice president at Thomas J. Herzfeld Advisors in Miami of the closed-end funds. "The discounts have widened because brokers aren't pushing them, leverage has magnified net asset value losses and funds are cutting dividends."

Her firm is buying closed-end funds at discounts that average at least 13%, then quickly selling when the discount narrows. And the firm has a lot to choose from: There are 180 such funds selling at discounts wider than 20%. Among those the firm is buying are out-of-favor loan participation and high-yield bond funds.

Gondor declined to comment on funds her company favors. But in the recent past, it has bought Black Rock Preferred and Equity Trust, Morgan Stanley Emerging Markets Domestic Debt Fund and the Advent Claymore Enhanced Growth Fund.

In early October, Herzfeld Advisors put money to work in closed-end junk bond funds yielding in the double digits and selling at more than 20% discounts to their net asset values. A flight to quality has driven down junk bond prices, Gondor says, to the point where it pays to take risks in return for high profits.

Like many other securities, closed-end preferred stock funds have been hit hard by the national financial crisis. Gregory Phelps, who manages John Hancock's stable of five closed-end preferred stock portfolios, says that more than $40 billion worth of outstanding preferred securities were wiped out during the week of September 15. There is also fear that giant insurer AIG could default on its own preferred stock after the announcement that the Federal Reserve would take it over.

"While we believe these recent preferred stock defaults are one-of-a-kind special situations that are unlikely to be repeated, we also believe that it will take a sustained rally in financial common stocks before preferred stocks recover," Phelps says. "They are now being valued as equity surrogates."

John Calamos, manager of five Calamos Asset Management closed-end funds, says that while his funds' share prices are down, the portfolios had a very low stake in AIG and no positions in Washington Mutual, Lehman, Fannie Mae or Freddie Mac paper.

"We are not immune from the current widespread negativity and its impact on the overall market," Calamos says. "Despite these challenges, we continue to maintain a positive long-term outlook. We intend to take advantage of the many opportunities resulting from the current market dislocation."  

Some closed-end fund shareholders are taking advantage of the dislocation in the stock market to convert their portfolios into exchange-traded funds. One such fund to make the transition recently was the Claymore/Raymond James SB-1 Equity Fund, a diversified closed-end management investment company that agreed to a reorganization in early September. The investment objective of the newly created ETF is to seek capital appreciation by investing in the Raymond James SB-1 Equity Index, which comprises stocks rated as strong buys by Raymond James analysts.

As a closed-end portfolio, the SB-1 Equity fund had been trading at a 10% discount to its net asset value for a long time, primarily because its distribution rate was very low, according to Christian Magoon, president of Claymore Securities in St. Louis.     

He says the chief reason the shareholders sought the fund's conversion into an ETF rather than into an open-end fund, which is another solution to tackling steep price discounts, is that ETFs can trade continuously, whereas an open-end fund trades once per day at closing.

"The fund had a provision for making it open-ended if it traded at an average discount of 10% or more over 18 months or 10% or more for 75 days in a row," he says. "Longer term, we believe that converting to an exchange-traded fund [instead] opens it up to a wider audience, compared to the closed-end fund structure. The size of the ETF market is twice as much as closed-end funds."

It helps that Raymond James' "strong buy" rated stock picks have done well over the past five years up to July, according to Zacks Investment Research in Chicago. In that period, Raymond James was ranked in the top ten brokerage firms, based on the total return of its stock picks, and it was ranked No. 1 for the year ended in July.

As an exchange-traded fund, the Claymore/Raymond James SB-1 Equity Fund now sports a lower expense ratio than an open-end fund and is more tax-efficient. Meanwhile, investors can short the exchange-traded fund as a hedge or bet that the fund will drop in value. On top of that, ETF holdings are transparent.  

Among other funds that have been converted into ETFs are the United States First Trust Advisors Value Line 100 Fund and the First Trust Advisors Equity Allocation fund in the U.S. A few Canadian closed-end funds trading on the Toronto Stock Exchange have been reorganized into ETFs as well.  

Richard Kang, an analyst and president of The Beta Brief (, says these conversions make sense because there are more actively managed exchange-traded funds trading on stock exchanges. Kang predicts investors will see more such reorganizations, particularly in funds focusing on specific countries or themes. The reason is that ETFs are attracting a lot of attention and assets.

"Actively managed ETFs are transparent, liquid and have tax advantages," he says. "It is part of the reason they are getting a lot of attention. PIMCO and other large investment companies are getting into the business. That will create more interest in exchange-traded fund conversions."

A couple of research studies suggest that investors could benefit from smaller, more specialized closed-end funds converting into an open-end structure. One study by Aigbe Akhigbe, a finance professor at the University of Akron, suggests that smaller funds converting amid weak market conditions show stronger performance gains than volatile high-cost closed-end funds. That study was published in the Journal of Investment Management in 2005.

Meanwhile research by Joel Harper, a finance professor at Oklahoma State University, found that ETF country funds offer higher risk-adjusted rates of return than closed-end country funds. That study was published in the Journal of International Financial Markets in 2004.

Although the conversion may be a smart move, it should be decided case by case. "A lot of closed-end funds are thinly traded and use leverage," Kang says. "Depending on the structure of a closed-end fund, it may be difficult to reorganize as an exchange-traded fund."

He also says that whereas the fund companies hope to convert the funds as a marketing move to appeal to investors, it is a move that may benefit money managers who want to short specialized ETF sector funds for profits or to hedge their stock picks.

The deep discount at which closed-end funds are trading has given rise to another phenomenon as well: Institutional investors and traders have been buying closed-end funds at a discount and shorting comparable exchange-traded funds. They then close out their positions for a profit.

For example, in the third quarter of 2007, some investors bought closed-end real estate stock funds and simultaneously shorted REIT exchange-traded funds for a profit. Although such arbitrage activity between closed-end funds and ETFs has slowed, Gondor says it was a popular strategy in 2007 and early 2008.

Today, however, some hedge fund managers are going long in closed-end funds because of the record discounts. "You are more likely to see arbitrage under normal circumstances or when there are small disruptions in the market," Gondor says. "But hedge funds and institutional investors are backing off today."