Open-Ended Profit Opportunity in Closed-End Funds

By Lee Bellinger / March 3, 2014

Buy Stocks, Bonds, and Precious Metals at BELOW Market Prices

Investment analysts often talk of “undervalued” assets, but it’s a relative term. There is usually no objective way of knowing whether you’re buying an investment for less than what it’s really worth. You can only buy a stock, a bond, or a gold coin at the price the market has determined it is worth at the time you decide to buy.

But what if you could buy investments for less than their market prices at any given time? Well, actually, you often can – through vehicles known as closed-end funds.

What Is a Closed-End Fund?

A closed-end fund (CEF) holds a basket of assets – stocks, bonds, even tangibles such as gold bullion – just like a mutual fund or exchange-traded fund. But a CEF doesn’t work like an open-ended mutual fund whose price tracks the net asset value of its holdings. A mutual fund manager increases or reduces the fund’s asset exposure as investors buy or sell mutual fund shares. A CEF’s price, on the other hand, is determined directly by the market.

If a CEF holds a basket of stocks with a total value of $500 million, for example, it can trade at a premium or discount to that total asset value. The fund’s shares could be valued by the market at $500 million, $550 million, $450 million, or theoretically any price.

Closed-end funds often trade at substantial discounts. And therein lies the opportunity.

Same Stocks, Cheaper Costs

For example, in the energy and natural resource sector, Blackrock Resources & Commodity (BCX) trades at a 14.6% discount; Petroleum & Resources (PEO) trades at a 15.5% discount as of this writing.
These CEFs hold some of the same blue-chip stocks – ExxonMobil, Chevron, Schlumberger, etc. – that ETFs and mutual funds focusing on the same sector hold. By buying one of the CEFs, you effectively get to own more shares of these stocks (and therefore more in dividend payouts) than you could through investing the same amount in a conventional open-end fund or in the stocks directly.

Why Pay a Premium for Gold
When You Can Get It at a Discount?

Right now, a couple of the closed-end funds that hold precious metals bullion trade at discounts. The Central Gold Trust (GTU), which holds more than 97% of its assets in gold bullion, sells at an approximate 4% discount. Yet it has normally traded at a premium. In 2008 and 2009, it got up to a premium of as high as 30%!

You can use the swings in CEF premiums and discounts to engage in low-risk arbitrage trades. Investopedia defines arbitrage as, “The simultaneous purchase and sale of an asset in order to profit from a difference in the price. It is a trade that profits by exploiting price differences of identical or similar financial instruments, in different markets or in different forms.

This isn’t speculation we’re talking about. This is one of the few types of trading that objectively puts the odds in your favor and actually helps you boost your expected returns while lowering your risk!

If markets were always efficient and asset prices always reflected all known information, as some people imagine the case to be, then there would be no opportunity for ordinary investors to profit from arbitrage. But the wild, irrational gyrations of premiums and discounts on closedend funds prove that markets don’t work in practice as efficiently as economists’ models suggest they should. A rational investor can profit from arbitrage opportunities made possible by irrational market environments.

For example, when GTU trades at a significant discount, you could buy the instrument with the aim of holding until it begins selling at a high premium. Once it’s trading at a premium, you have the opportunity to pocket it by switching out of GTU and into a different gold exchangetraded product that trades at no premium – or into physical gold bullion. Later, if GTU begins selling at a discount, you can go the other direction by selling gold instruments you own at market prices (plus any realizable premiums) and using the proceeds to buy the gold closed-end fund at a discount. By executing these trades, you’ll end up with more ounces to your name without engaging in market timing or other speculative trading strategies.

Tax Advantages that May Be Worth Paying Up For

If you are considering a precious metals exchangetraded product for a long-term holding, it may be worth paying a small premium for a closed-end fund or trust instead of an open-end ETF. The reason? Closed-end products may be taxed as corporations and be subject to favorable long-term capital gains treatment.

For example, Sprott Physical Platinum and Palladium (SPPP) is a closed-end trust that holds “unencumbered and fully-allocated Good Delivery physical platinum and palladium bullion.” One of Sprott’s biggest competitors, ETF Securities, offers physical platinum and palladium instruments that receive more adverse tax treatment.

Precious metals analyst Ben Kramer-Miller explains, “The platinum and palladium held by the ETF Securities funds are treated as collectibles, and profits on them will be taxed at 28%. Profits on SPPP holdings will be treated as if it were a stock, meaning that if you hold the fund for longer than a year then it will be taxed at 15% or 20%, depending upon your tax bracket.

As of this writing, the premiums on the Sprott physical
metals trusts are as follows:

• Sprott Physical Platinum and Palladium
(SPPP): 0.1%
• Sprott Physical Silver (PSLV): 4.4%
• Sprott Physical Gold (PHYS): 0.2%

You can find the current premium/discount on these instruments on Sprott’s web site (http://sprottphysicalbullion.com) or by calling their office (877-403-2310).

Back in April 2011, when the Sprott trusts were trading at elevated premiums, we stated in this newsletter that we “don’t find either the Sprott Physical Gold (PHYS) or Physical Silver (PSLV) trusts to be attractive candidates for purchase at this time… PHYS and PSLV trade at sizeable premiums to net asset value. For PHYS, the premium is 6.7% (and has been as high as 23.9%). For the PSLV, the premium is 18.5% (and has been as high as 20.3%).”

Now that the premiums have come down, the Sprott trusts look relatively more attractive. If you decide to own them, it’s a good idea to keep track of the premiums on a weekly basis. If they shoot back up into the double digits, you may find it advantageous to sell and use the premiums you bank to purchase physical metal or a different instrument that isn’t selling at a premium. It is my prediction that premiums on closed-end instruments such as GTU and the Sprott trusts will surge as metals prices rise and verified physical supplies become scarce.

Beat the Pros at Their Own Game

Closed-end funds purchased at opportune times – ideally when they’re trading at a discount – give you superior risk/reward characteristics compared to other ways of investing. Yet virtually nobody on Wall Street talks about how ordinary investors can exploit the opportunities in closed-end funds. You never hear CNBC talk about them. Perhaps that’s because closed-end funds are dwarfed by mutual funds, ETFs, and hedge funds in terms of total market capitalization.

For the little guy, carefully selected closed-end fundscan be one of the best paths to beating the market.


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