The last few days have sent a lot of investors scurrying back to the sidelines.
The correction, which I've been calling the most widely anticipated correction in years, has reignited fears that even an anemic recovery might be farther away than most investors expect.
If you turn on CNBC, you'd think it was just as bad as last fall. That was when forced-selling was driving down the price of every asset class. The bankruptcy of automakers was going to result in a catastrophic loss of 3 million jobs. The economy was shedding 500,000 jobs a month and the only solution to prevent unemployment from climbing past 8% was $787 billion in government stimulus.
It was a period when no one really knew what was going to happen next, how bad it would get, and uncertainty was dominant.
Since then a lot has changed. It turns out the world economy is not coming to an end. Granted, it's going look a lot different throughout a prolonged L-shaped recession. But the economy is not going to fall apart completely.
Despite it all, the markets are acting like we're at the precipice of a financial cliff again. And that is creating opportunities out there.
Of course, during downturns you just have to look a little harder for the opportunities. That's why I've been turning back to the often overlooked closed-end funds (CEF).
The Contrarian Way to Trounce Mutual Funds
CEFs can be excellent tools to help you beat the markets if used correctly. Or they can just as easily drag down overall returns if used incorrectly. As with everything else in the investing world, it all depends on timing. Right now the time is almost right for CEFs to be helpful.
You see, CEFs trade at a premium or discount to net asset value. The net asset value (NAV) is the total value of all the securities - stocks, bonds, etc. - held by the fund. If the CEF trades for more than its NAV, it's trading at a premium. If the CEF's market price is less than the NAV, it's trading at a discount.
When the markets in general or a sector is really hot, demand for a CEF will sometimes make it trade at a premium.
The perfect example of this is when China was all the rage back in 2007. The few China CEF's were fetching premiums of anywhere between 20% and 40%. That's like paying $1.20 to $1.40 for each dollar in assets.
CEFs trade at a discount to their net asset value most of the time though. That's because it doesn't make much sense to pay more than the underlying value for an asset. After all, would you take your money to the bank if they credit your account for $1 for every $1.10 you deposit? Well, that's what it's like when you buy a CEF at a premium to NAV.
It's their unique structure which allows investors to use CEFs to buy into the market or a sector at a discount. Since they trade at the steepest discounts when a particular sector follows out of favor, buying them when discounts are high is a good way to place a contrarian bet on a sector at a better price than any mutual fund or ETF would offer otherwise.
Getting a Head Start on Stocks
Buying CEF's at steep discounts is like getting a head start on stocks. You get instant diversification, a lower starting point, reduced risk, and greater upside potential.
Just take a look at the opportunity shaping up in healthcare. We all know the healthcare sector has exceptional upside potential. It's something we've been over quite a bit over the past year.
Despite the obvious opportunity, I've recommended waiting for the right time to buy in. We knew the government was going to get involved, there would be a lot of debate, and there would be a lot of uncertainty in the sector along the way. It's all playing out in real time now.
So here's the thing. Trying to time a bottom in the market, a sector, or a stock is next to impossible. But by using CEFs we can get in cheaper and be positioned for the all the upside with less risk and volatility too.
The perfect example is BlackRock Health Sciences Trust (NYSE:BME). BlackRock's Health Sciences Trust is a CEF focused on the biotech and pharmaceuticals sector. The fund's top holdings include biotech bellwethers like Wyeth (NYSE:WYE), Amgen (NASDAQ:AMGN), and Gilead Sciences (NASDAQ:GILD).
Nothing too exciting there, I know. You'd find these stocks in most any biotech or pharmaceutical focused ETF or mutual fund. All of the stocks are widely held, actively traded and could easily be bought and sold with a quick phone call or a few clicks of the mouse.
But you'd have to pay full market price to buy them directly through the market, through an ETF which is required to trade very close to its NAV, or with a mutual fund which has its price matched to the market at the end of the day.
CEF's are different. If you wanted exposure to these stocks and the rest of the sector, you could buy a CEF like the BlackRock Health Sciences Trust. It currently trades at a discount of more than 9% to its NAV. It's like starting out 9% ahead of the market. On top of that, the CEF pays cash distributions at a 7.3% annual rate. That's higher than most of its holdings.
That's the main advantage of CEFs. They are a way to win more when the market goes with you and lose less when the market goes against you. The discount offers a buffer against the downside since it's already undervalued. And CEF's offer more upside because they increase in market value from an increase in the NAVs and as the discounts shrink or turn into a premium.
Another Tool in Your Investing Toolbox
As you can see, CEF's are a way to buy discounted positions, reduce risk, and increase upside potential. They can be very helpful for any portfolio if purchased at the right time. But that's not all CEF's are good for.
As we've looked at every time the markets take a turn for the worse, we use CEF's (as a group) to help us get a firm reading on bearish sentiment. For instance, last October we were using CEF market data as one of the Five Signs of a Market Bottom.
At the time the markets were collapsing and identified:
Two weeks ago, when the markets seemed like they just couldn't get any worse, only 18 of the 597 closed-end funds were fetching a premium. That was the lowest number I have ever seen. The bearish sentiment in closed-end funds was peaking.
Now, 57 of the funds are trading at a premium. By historical standards, anywhere from 35% to 50% of them should be trading at a premium during a flat market. With only 9.5% of them trading at a premium to net asset value, the markets are clearly overly bearish.
Right now, only 17% of them are trading at a premium. Which proves bearish sentiment is low and could get a little bit worse, but it's not likely to get much worse from here.
With that in mind, I hope you take this opportunity to look at all the CEF's out there. They offer so many more advantages over ETFs or mutual funds. And as we enter a market period where 10% to 15% annual returns are the exception rather than the norm, CEFs will help you work out a bit of extra return with less risk. And that's a valuable proposition in any type of market.