Selloff spawns bargains among closed-end funds

WHAT ARE WE LOOKING FOR?

About a year ago, we took a look at closed-end funds - sort of a hybrid between stocks and mutual funds. They offer an intriguing place to look for bargains - particularly given the sharp downturn in the markets in recent months.

Closed-end funds resemble mutual funds, in that they hold a basket of underlying assets that can rise and fall in value. But they also trade on public markets, much like a stock. There are about 220 closed-end funds listed on the Toronto Stock Exchange.

On a basic level, assessing the attractiveness of a price for a closed-end fund in the open market is a pretty simple and transparent exercise. Funds are required to regularly disclose the net asset value (NAV) of the fund - i.e. the value of the underlying assets. If the market price is above the NAV per share, the fund is trading at a premium, and isn't a bargain. If the price is substantially below the NAV per share, it's trading at a discount, and presents a potential bargain.

DISCOUNTS HAVE WIDENED

All things being equal, closed-end funds tend to trade at a small discount to NAV - typically in the range of 2 to 6 per cent - because they are fairly illiquid products that can be difficult to move in a hurry, and the discount compensates investors for this risk. But any discount well above that range suggests the market is undervaluing the fund.

Not surprisingly, the sharp selloff in the equity market has spawned more and bigger bargains among closed-end funds than we saw when we last looked at them in late 2007. At that time, the name at the top of our list - United Corporations Ltd. - was trading at a 28-per-cent discount to NAV, while other leading bargains were in the 10-to-20-per-cent range. Now, list-topper Capvest Income Corp. is showing a whopping 61-per-cent discount, and much of the top 20 names offer 25 to 40 per cent.

CHEAP FOR A REASON?

The discount-to-NAV calculation is really just a starting point; investors need to look beyond this number to identify if there are any fundamental reasons for certain funds to be so deeply undervalued by the market. For example, some funds may not offer retraction (the right to sell the units back to the issuer) or may charge a substantial retraction fee - which in a volatile market can be a major disincentive to hold an illiquid security. In other cases, the market may doubt the stated value of the assets held by the fund, particularly in cases where they are private assets that don't have a visible market value.

Some funds have seen their previously popular asset base falling out of favour with investors. One striking example is Urbana Corp., which a year ago was trading at a steep premium to NAV but now is at a steep discount. The company specializes in investments in securities exchanges, a business whose potential for rapid growth has run into a brick wall with the financial crisis.

Closed-end funds - biggest discounts to NAV

SOURCE: GLOBEFUND