In the world of investing, discussions about overpriced stocks and funds are common, with pundits often making statements like “Tech is overvalued.” The Technology Select Sector SPDR Fund (XLK) is often mentioned as an example of an overpriced ETF. However, in technical terms, ETFs like XLK are rarely overpriced. This is because ETFs, like XLK, typically have a price that closely reflects the cost of buying all the individual stocks in the fund separately. Big Wall Street firms work to ensure that this pricing remains accurate, which is why ETFs like XLK are almost never discounted.
On the other hand, closed-end funds (CEFs) like the Highland Opportunities Income Fund (HFRO) can trade at significant discounts. Unlike ETFs, CEFs have a fixed share count, which means that the fund size cannot be easily increased by big investors. This allows CEFs to focus on specific mandates and trade at discounts that may not accurately reflect the value of their underlying portfolios. For example, HFRO is currently trading at a 50%+ discount, which means that investors can buy shares at a lower price than the actual value of the fund’s assets.
Despite some challenges, investing in discounted CEFs can offer significant advantages, such as higher yields. These funds can pay an average 8% yield, with some high-quality funds yielding 9% or more. This can provide investors with a steady stream of passive income, with the potential for significant returns. Furthermore, discounted CEFs often have safer dividends, as the discount allows the fund managers to maintain distributions to shareholders more easily. This can result in a more sustainable income stream for investors.
One strategy for getting more sustainable income from CEFs is to focus on the yield on net asset value (NAV) calculation. By understanding the relationship between a CEF’s market price and the actual value of its underlying portfolio, investors can determine the sustainability of the fund’s dividends. Discounts on CEFs can turn a high-yielding fund into a lower-yielding one on a NAV basis, making it important for investors to consider the implications of these discounts. With proper analysis, investors can generate consistent income from a mix of stocks and corporate bonds through discounted CEFs.
While discounted CEFs can offer attractive opportunities, there are risks associated with investing in premium-priced funds. Funds like the Gabelli Utility Trust (GUT), with a high premium to NAV, can present risks to investors. Maintaining high payouts in premium-priced funds can be challenging for fund managers, especially if they fail to achieve the necessary returns. Such funds may be vulnerable to dividend cuts or market volatility, which could lead to a decline in their market price. Investors should be cautious when considering premium-priced funds and assess the potential risks before making investment decisions.
In conclusion, while discounted CEFs can provide investors with attractive yields and income opportunities, investors should be aware of the risks associated with premium-priced funds. Understanding the relationship between a fund’s market price and its underlying portfolio value is essential for making informed investment decisions. By carefully evaluating the risks and potential returns of different funds, investors can build a diversified portfolio that generates consistent income and long-term value.
