Closed-end funds often get a bad rap, especially after the binding-up of the auction rate securities market; however, this oft neglected asset class can sometimes provide interesting opportunities for both current income and capital appreciation. Closed-end funds are the cousins of the “open-end” fund, aka the mutual fund. Closed-end funds raise capital through an IPO, (initial public offering) just like an operating company “going public.” These investment companies then operate along their particular mandate purchasing and managing investment securities. Shares of closed-end funds trade on the secondary market just like a publicly trade stock or bond.

A feature of closed-end funds is that they have to publish their assets in their public filings. This creates the opportunity for analysts to compare the value at which the fund trades in the public market (Market Cap) and the market value of the assets the company holds (Net Asset Value or NAV). Generally, the shares trade at a slight discount to NAV, accounting for management fees and various perceived risks. However they can also trade at NAV or above, especially if the manager is believed to have particular skill or the asset class is difficult to invest in directly.

Historically, when the equity of the closed-end funds has traded at a large discount (30% or more) to NAV, the equity of these companies has proven to be a good investment. We saw such discounts in the 4th quarter of 2008. Such a gap can emerge in a variety of settings, but clearly emerged in the panicked selling of the fourth quarter of last year.

This drove the market prices of many closed-end funds down well below NAV and simultaneously drove up their dividend yields, The holdings of many closed-end funds, such as those trading convertible bonds, bank debt, or high yield went into in free fall.

One specific example is the Advent Claymore Convertible Security and Income Fund (NYSE: AVK). During December, 2008, this closed-end fund provided exposure to convertible bonds at a 30% discount to replacement cost. We like convertible securities a lot right now because many are fundamentally undervalued due to forced selling by hedge funds. The characteristics of convertibles are very interesting in this market with such securities yielding between 10% and 15% while allowing investors to participate in an eventual recovery of equity prices.

Even as the market continued its decline in January of 2009, the assets held by AVK and other closed-end funds rose as total panic returned to ordinary fear. Markets responded by closing the gap between the equity price and the NAV; i.e. the shares went up.

We continue to find closed-end funds interesting and overly maligned. Despite the near-total pessimism in the markets right now, there still exist opportunities for diligent investors to make money and boost returns.

The reference to the closed-end fund does not represent a general recommendation to purchase or sell this particular security. Past performance is not necessarily indicative of future returns. Inherent in any investment is the possibility of loss, including all capital invested.

James L. Cahn