Closed-End Funds

   The Closed-End Fund (CEF) is an ancestor to ETF's. There are important differences between the CEF and ETF and open ended funds. When the CEF is created, the fund company raises a specific amount of money from new investors in an IPO (initial public offering). Then the money is invested in the assets specified in the fund's objective sector: stocks, bonds, MPL's or whatever. No new money is allowed in. The fund does not issue new shares to new investors. They also do not buy back shares of existing investors. If you hold shares in a CEF, then to sell, you must sell them on the secondary market just like a stock. The shares are priced throughout the day, allowing for a liquid market. Now here is the interesting part, the shares may trade at a price that is different from NEV. Remember that NEV (net asset value) is the sum of the value of the assets in the fund divided by the shares outstanding. Usually, a CEF trades at a discount to its NAV. This means that you can own the asset for less than they are worth. It also means that if you bought the IPO you have a loss. DON'T BUY IPO'S. If you buy a CEF at a discount, say 10% to NAV, you probably feel pretty smart. It may not last. Some CEF have traded at a discount for their whole lives. The trick here is to identify an asset class that is currently out of favor but you suspect that it will be in demand in the future. Even buying a CEF at a deep discount and selling at less of a discount will result in a profit. Premiums for CEF's are rare. Usually CEF's are purchased for the income they generate. Some asset classes I like for the CEF structure is Preferred Stocks and Convertible Stocks. These are hybrid shares that are not easily understood by many investors. Letting a professional manage them makes sense. Closed End funds can be selected from lists in Barrons weekly publication or The Wall Street Journal. The premium or discount from NAV is listed as well as the last years performance. Some funds in the asset classes I mentioned had returns of 30% or more last year and still traded at a discount. I would not chase an investment unless the outlook is still superior. My next post is about how I forcast the next market winners.

Exchange Traded Funds (ETF)

Before I get into ETF's, and how they differ from traditional Mutual Funds, I need to explain how mutual funds work. First of all, there are two basic types of mutual funds: open ended and closed ended. Normally, when mutual funds are discussed, we are talking about open-ended funds. These are funds that hold stocks, bonds, or whatever and the investments in the fund can change based on the decisions of the manager. He may find new investments that he adds to the fund at any time. "Open-ended" refers to the flexibility of the investment portfolio to change. On the other hand, a Closed-Ended fund starts life with a basket of stocks and keeps them for the life of the fund. I will discuss the Closed-End fund in my next post. Both of these types of funds are priced at Net Asset Value (NAV). Net Asset Value is calculated by multiplying the number of shares times the closing price of those shares and added up, then divided by the number of mutual fund shares outstanding. That's a lot of math. Imagine the fund has 600 stocks, there is no way that NAV could be calculated and published throughout the trading day. This is why the NAV is only calculated at the end of  the trading day. So how does that affect you? Well, if you owned an open-end fund and had a nice gain in it and one morning you turned on the T.V. and saw that the stock market was falling dramatically, you would want to sell your fund to preserve your profits, right? Too bad, you can't. You have to wait until the market closes before your order to sell gets executed. However, if you owned an ETF, it can be sold during the trading day. It trades like one single stock. The mechanics of an ETF are complex but the end result is that it gives you trading flexibility, low fees, tax advantages and transparency. There are now over 1500 ETF's  currently traded and they cover almost every asset class,ie, stocks, bonds, commodities realestate, etc. I use ETF's to make sector bets based on my forecasts. For example, if I think that defense stocks will outperform the market, I will buy an ETF  that holds defense related stocks. This one trade provides me with diversification in the sector with low fees.In my next post I am going to talk about Closed-End mutual funds which are the unloved cousins of ETF's.

MUTUAL FUNDS

As I mentioned in previous posts, I sometimes use mutual funds rather than investing directly in stocks. Some sectors of the market are more difficult to analyze due to unique accounting or business traits. Sectors like banking, real estate investment trusts (REITS), master limited partnerships (MLP), are good canidates for using a mutual fund for investing. There are some things to know before handing over your money to a mutual fund company. The first thing I look at in a mutual fund is the fees they charge to manage your money. Naturally, you will have to pay for the expertise they bring to the table, your job is to not overpay. Some mutual fund families specialize in low fees which is good for the investor, however, be aware that customer service may be lacking. The second thing I look at in a mutual fund is what is in the portfolio. I "kick the tires" by checking some of the stocks in the top ten holdings. Basically, if I wouldn't buy these stocks (due to high valuations) or any other reason, I look elsewhere. I also look at past performance even though this is not predictive of future returns. The fact is that 80% of mutual fund managers cannot beat the performance of an unmanaged index which is their benchmark for performance. If a fund has had superior returns than the index and other competing funds, look to see if the same manager is still there. Long tenured fund managers with index beating performance are rare. Don't buy a fund based on the performance of a hot manager who is no longer in charge. Finally,pay attention to when distributions are made to fund shareholders. If a fund usually makes a distribution in December, I would not buy into it before the distribution date. The reason is that some of your investment is just handed back to you, creating a tax liability and reinvestment task. This is only true in taxable accounts, retirement accounts don't have this problem.
     This is just a brief overview of mutual funds. Investing through mutuals can be an easy way to gain exposure to stocks but can also be a way to get mediocre returns with high fees. The pitfalls are many so learn the basics. A very popular way to invest in mutual funds for the last 20 years has been to buy a low fee index fund from a company like Vanguard or Fidelity. These are unmanaged funds that will track the general market like the S&P 500 index. Some experts predict that managed funds will outperform in the coming years. Only time will tell. A competing product to mutual funds has emerged in recent years. It is called an Exchange Traded Fund (ETF). Billions of dollars have left traditional mutual funds and flowed into ETFs. I will explain the differences in my next post.

Ratio Analysis

I have talked about the P/E ratio and how to manipulate it to predict future stock prices based on changes in earnings or multiples. What if a company does not have any earnings? Sometimes young companies are so busy selling and developing products that they are not yet profitable. Usually these are smaller companies with limited resources to accomplish profitability yet. This can be a rich area to mine for investment. So how do we analyze such companies? Another tool in the Ratio Analysis tool box is the Price/Sales ratio. This ratio is best used as a comparison with other companies in the same business. If nothing else, it can give the investor an idea if the stock price is too high compared to other businesses. What this ratio is telling you is how many dollars you are willing to pay for $1 of sales in this company. The hope here is that if sales growth is high, then earnings are soon to follow.
     Another ratio that may be used is the Price/Cash flow. Cash flow may also be expressed as EBIDTA which stands for earnings before interest, depreciation, taxes and amortization. Sometimes, companies have a lot of depreciation which clouds the earnings picture. This accounting measure cuts through the crap to determine whether this company can actually pay its bills.
     As a conservative investor, I like to stick with established companies with a long record of earnings and increasing dividends. However,  I also recognize that the really spectacular growth comes from young companies on the cutting edge. This is why I bring up these two ratios. I would only consider a small portion of my portfolio in these small-cap names. That being said I would point out that late in a bull market, small caps tend to outperform the large cap stocks. The current bull market in stocks is over 7 years old, nearly a record. I usually invest in small caps through mutual funds because the names in this space are unfamiliar to me and I don't have time to sift through the hundreds of stocks to identify potential winners. Sometimes its best to leave the heavy lifting to the pros. My next post will be about investing in mutual funds. Its not as simple as"investing and forget it". I will talk about pitfalls that should be avoided.