Buying Deep Discounts to Boost Returns

08/12/2010 11:30 am EST

Focus: FUNDS

Richard Lehmann

Publisher, Forbes/Lehmann Income Securities Investor

Richard Lehmann, publisher of the Forbes/ISA Closed-end Fund & ETF Report, says closed-end funds selling at deep discounts will help maximize your profits.

Even if the market is unpredictable and random, investors may still have a way of maximizing their returns.

Our first such portfolio was constructed to take advantage of low expense ratios. Low- expense-ratio index funds outperform [most] mutual funds of all types on fee difference alone.

Our second portfolio will take advantage of the supply/demand characteristics of closed-end funds. That is, closed-end funds trade independently of their net asset value. A fund can hold $10.00 worth of stock, but sell on the open market for only $9.00, allowing an investor to buy the stocks in their portfolio at a 10% discount.

Closed-end funds are sensitive to sentiment as well as actual market performance. If our random-walk hypothesis is correct, the performance of an individual closed-end fund is random, [so] the worst performing fund has just as good a chance of future outperformance as the best performing fund. In this case, an investor gets to buy it at a substantial discount.

The DCW Total Return Fund (NYSE: DCW) is a closed-end fund that trades at a 17% discount to its net asset value. The fund was originally configured to invest in global real estate. However, a recently proposed merger with a sister fund, the DCA Total Return Fund (NYSE: DCA), aims to change the investment focus away from real estate.

DCW [closed Wednesday] at $4.77, with a net asset value of $5.74, giving the fund a discount of [around] 17%. The fund has a relatively low yield because [it] is not as interested in current income as in total returns, and all of its dividends are interest, with no return of capital.

DCW is invested 66% in equity, with the rest in preferred stock. Its largest holding is Apple (Nasdaq: AAPL), and 99% of its holdings are in US equities. By its holdings, it certainly has drifted away from its original emphasis on global real estate!

The merger, if approved, is expected to occur in the late third quarter of 2010. We expect the discount to decline once the merger is complete.

Currently China wants to slow down its hot property market and is imposing financing restrictions such as limiting the number of purchases allowed per person and requiring that buyers pay cash. Still, the rate of household formation in China is increasing, while it is decreasing in the US.

Our pick to exploit the Chinese market is the RMR Asia Pacific Real Estate Fund (Amex: RAP). It invests in real estate common stock in the Asia-Pacific region. It [closed Wednesday] at $16.39. Its net asset value is $20.40, giving the fund a discount to net asset value of -19.6%.

It has 59% of its assets in diversified real estate, followed by 11% in hospitality and 10% each in retail, office properties, and cash. The fund does not use leverage.

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