Using CLOSED END FUNDS for GROWTH and INCOME

If you’re looking for more income, this article could shed some light on the advantages of deeply discounted closed end funds and demonstrated advantages over no-load mutual funds, exchange traded funds (EFT), and loaded mutual funds for income investors. In my over 20 years of investing I’ve constantly seen people make the same mistake of paying too much for their investment. This article is designed to educate on a very unique investment style designed to achieve a greater probability for growth, higher current income, and lower overall risk.

First some basic facts about closed end funds

According to Lee, Shleifer and Thaler (1990) from 1980-1998 the average discount on most US closed end fund varied from 0-20% and averaged around 5%.

According to the Investment Company Institute, at the end of 2005 there were 634 closed-end funds with combined assets of about $276.35 billion.

Many of the same managers of open end funds have loaded and no-load funds along with closed end funds and often have similar investments, risk, and returns.

The four main factors about closed ended fund from Lee, Shleiler and Thaler.

Closed end funds are:

1. Issued at net asset value (NAV) or above

2. On average they trade at a relative discount

3. The discount or premium is subject to wide variations over time and across all funds and classes.

4. At termination, the price converges back to NAV

How to increase your income

I will use the Gabelli Dividend & Income Trust or symbol (GDV) as our example. It’s currently trades at a 15.71 % discount and has a 6.64% income from dividends. What this means is that for every $85 dollars invested you will have $100 that’s working for you. At the end of every day the markets calculates the value of the portfolios. For instance, your portfolio is worth 100,000 dollars you could sell it to your spouse or someone else for $85,000 that is what a 15% discount means. Now if that $100,000 portfolio was paying 5.65% or $5,650 dollars per year in income as dividends, then a person now bought it at $85,000 will still receive that same dollar amount or $5,650 income. But since the income from the portfolio is the same and the cost is about $15,000 dollars lower than the new current income is 6.64%. We would like to take you through three simple examples, since the Gabelli investing family has closed loaded and no load funds. I would make the same assumption on the next three examples that the manager had the same stocks in each structure.

#1 Closed end fund

(a) You invest at a 15% discount and immediately start receiving almost a 6.64% current income. If you get lucky a buy out firm purchases the fund in the second year and turns it into a no load open-ended fund. The net asset value does not change. You still make 15% in principle and about 6.64% income per year; it works out to be 13.86 % per year over two years assuming no market change.

(b) If there is no buyout and the selling price and NAV did not change at all, you make 5.65% per year over two years

#2 No-load mutual fund & ETF You invest in a no load fund trading at NAV or ETF with no sales change and it has no change in net asset values in two years. At 5.40% per year in dividend and thus have a return of about 5.40% per year over two years.

#3 Loaded mutual fund You invest in the Gabelli fund with a 5.75% load fund. With a 5.75% load you’re paying $105.75 dollars for every $100 that gets invested, it will take over a year in dividends in this case to break even in principle. Again if the asset value does not change in two years your income is about 5.3% based on the dividend at NAV and that would net you about a 2.6% total return per year over 2 years.

Comparing #1(a) to #2 scenarios for the Gabelli funds.

If a buy-out did occur #1(a) would received a 15% gain in principle plus still receive about a 15% higher current income, the old closed end fund would be repositioned into #2 category as a no-load fund trading at NAV.

Conclusion: The larger the discount the higher probility of making money in principle

Comparing the #1(b) to #3 scenarios on the Gabelli funds

The closed end fund from the same family was about 20% cheaper for every dollar invested in principal plus assuming similar stocks you would receive about a 20% higher income per year.

Conclusion: The larger the discount the higher the income each year

Risks

The only two addition risks that we could identify was that closed end funds have:

1. Higher volatility- meaning the price could go up and down more than traditional mutual funds.

2.* Even if purchased at a large discount the discount could become even greater over time.

To Reduce Risk

With an effort to reduce the risks associated with closed ended funds at deep discounts with high income we recommend diversification using many different asset classes and fund families utilizing asset allocation approach. In our growth and income model we use 7 different asset classes to provide a balanced portfolio. This structure was designed to minimize fluctuations. For example, an event that might hurt one class of investments might benefit another. An example of this is after the 9/11 terrorist attack and the 2000 stock market crash. In both cases the stock market had a tremendous sell off, but the high grade bonds had very large rallies. During those two events the stock market and high grade bonds were not correlated. Many experts believe diversifying between asset classes is the single best way to reduce volatility risk

When building portfolio’s we use a selection criteria that focus on: unique asset classes, deep discount , high yield, consistency of payments, ongoing fee’s and other factors we incorporate into the selection are, past track record of the fund, and past track record of the management team, and of course the management team. We apply our selection criteria to over 600 closed ended funds with a goal to find only 1 or 2 in each asset class that fits our needs.

Simply don’t put all your eggs in one basket. If the assets classes are non-correlated then this reduces the portfolio risk.

How to Increase your Principle

Now performance here is what the USA Today said about discounted closed end funds “If you're patient, buying funds at a steep discount can be extremely lucrative? For example, suppose you divided the closed-end universe into fifths, starting with the most expensive. The priciest 20 percent gained 48 percent in the past five years. The 20 percent with the steepest discounts, however, soared 160 percent.”

According to USA today the returns for largest discounted closed end fund beat the premium funds by 300%

Common Sense

It just makes good common sense. The less you pay for an investment the higher the probability of getting a better return. Finding an investment at a 10-20% discount for similar portfolio’s that others are paying a premium is very basic to investing. The next time someone is selling you a ETF or a mutual fund with a 5% load just for income just remember this paper because you might be able to find a similar portfolio from the same managers in a closed end fund with 10-20% cheaper plus receive about a 10-20% higher current income.

If you invest in a deep discount closed end fund with high income you receive more invested principle for less money.

Our current growth & income model average statistics

Portfolio Average Yield 7.61%

Portfolio Average Discount to NAV 14.12%

Number of Closed end funds 8

Different fund families 8

Current Asset classes- Large Capitalization Growth, Growth, Global Income, Utilities, Foreign Government Income, Real Estate, Preferred, and Convertibles

Conclusion

It is our conclusion that when you pay less for investments you have a greater probability of achieving a higher return. With income investments we believe you could achieve the best of both worlds. With deeply discounted closed end funds with high income we believe you have a greater chance of increasing your principle, plus at the same time earning as much as a 20% higher income today.

Hopefully this paper demonstrated that utilizing deep discounted closed end funds combined with professional asset allocation, a portfolio can achieve a greater probability for growth, higher current income, combined with lower overall risk.

Randy Durig manages the several Portfolio's including the Growth @ Income Portfolio to see the full list go to www.durig.com

Durig’s Monopoly Blue Chip Portfolio National Performance Rankings: 3rdIn the United States, Ranked by 3 year annual return , for Large Capitalization Blend, 4th Quarter 2005, By Money Manager Review

Durig Capital is a registered investment advisor. If you know someone that would like our research services just enclose the name, day time phone, and email or rdurig@durig.com or call toll free 877-359-5319

Randy Durig owns Gabilli dividend and income trust in discretionary client's portfolios and in his own account. Past performance is not a guarantee for future returns. All information we believe to be correct but make no guarantee to accuracy