Closed-End Mutual Funds in Volatile Times

General American Investments, Source Capital, and their ilk are old and unsung. But they're solid, and can be smart investments, especially now

By Lewis Braham

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Jason Ford

Spencer Davidson should be famous. The manager of General American Investors fund has delivered a 9.1% annualized return over the past decade, through Sept. 30, more than tripling the 3% of the Standard & Poor's 500-stock index while still investing primarily in blue-chip stocks. He has an enviable dossier: At 66, he has more than 40 years of investment experience and was a member of the legendary 1966 graduating class of Columbia University's MBA program, which produced well-known hedge and mutual fund managers Mario Gabelli, Art Samberg, and Leon Cooperman. So why haven't you heard of him? Because General American is a closed-end fund.

Often perceived as the older, unevolved cousin of modern mutual funds, closed-end funds launched in the U.S. in 1893 (the first mutual fund came in 1924). They are curious creatures. While the value of a mutual fund is simply the sum of its holdings at the end of the day—a direct reflection of the gain or loss in what it owns—the value of a closed-end fund isn't nearly as straightforward. It trades on an exchange like a stock, and its price can be buffeted around the same way, sometimes without any obvious catalyst. Unlike a mutual fund, which takes in new money, closed-end funds have an initial offering and often, that's that—new shares are rarely issued, and usually there's no set liquidation date for the fund. To buy in, you purchase shares on an exchange from another investor. The same goes for selling.

One of the quirky things about closed-ends is that most trade at a premium or discount to the value of their portfolios. That may be because a manager is highly regarded or a fund's style is out of favor. On a well-run fund, a discount is an opportunity: Buy in at, say, a 10% discount to its net asset value (NAV), and you effectively get a dollar's worth of assets for 90 cents. Think of it like this: If you like Costco Wholesale (COST)—a General American holding—and you buy it on the stock market, you'd pay about $58 per share. But since General American trades at a 13.2% discount, you can buy exposure to Costco through the fund for 13.2% less than you'd pay to own it directly. The expectation when you buy, of course, is that the discount will eventually narrow, and you'll sell for a gain.

The closed-end structure can benefit shareholders. At regular mutual funds, investors tend to chase performance, throwing money at hot managers who then often struggle to find enough good places to invest it. When performance cools, shareholders tend to flee, which can force a manager to meet redemptions by selling into a falling market. That's not an issue with closed-ends, since investors can't yank cash out. It's a huge advantage for the funds. Says Davidson: "Since our capital is permanent, we have the luxury of holding for the long term and buying in the face of uncertainty."

General American is a particularly well-run fund. It has a low turnover ratio of 20%, meaning it typically holds stocks for five years; the average stock mutual fund turnover tops 80%. Not every closed-end is run as well. "It's part of a dying breed of older, closed-end funds targeted by dissident shareholder groups," says Cecilia Gondor, executive vice-president of Thomas J. Herzfeld Advisors, a Miami investment adviser. (General American is not under attack.) Often, when discounts get large enough, activist shareholders try to force a fund to sell its assets and liquidate so that the full value of the assets gets recognized and they make a fairly quick gain.

Gondor doesn't recommend buying and holding the funds, preferring to buy when discounts are wide and sell when they narrow. She says funds run by good managers can be attractive to hold over extended periods as long as investors buy the fund at a discount greater than where it has historically traded. Once you own the fund, of course, you don't want to see the discount widen. "General American has traded at a discount wider than 10% most of this year," she says. Over five years, the discount has been 8% to 12%. "