Investors interested in putting some money into a fund specifically focused on Chinese equities can choose among multiple China ETFs. Alternatively, there are some China-specific closed-end mutual funds. The same choice is available for many nations around the world; while both versions trade like stocks there are crucial differences to consider.
PASSIVE OR ACTIVE?
ETFs typically track an index, so single-country Chinese ETFs offer the virtues of index funds--broad market exposure, low costs, tax efficiency—as well the possible risk of overexposure to hot sectors that can occur with capitalization-weighted indexes. Closed-end funds are often actively managed; in countries with relatively inefficient markets, canny stock picking might pay off.
However, many active funds fail to beat their benchmarks so investors have manager as well as country risk.
To see the possible differences, the index-tracking iShares MSCI China ETF is almost entirely invested in large-cap stocks (73% in the “giant’ category) while the closed-end China Fund has over 20% of its assets in mid-, small-, and micro-cap issues. Following the index, the ETF likely will remain a mega-cap fund while the actively-managed closed-end entry could change directions.
PREMIUMS & DISCOUNTS
Closed-end funds typically trade at a premium or discount to the net asset value (NAV) of their holdings while ETFs often trade at or near their NAV. Thus, ETF investors may have scant concerns about up or down moves in a fund’s premium or discount after a purchase.
Conversely, “The absolute key to investing in closed-end funds is to screen for premiums and discounts to NAV,” says Wes Moss, chief investment strategist at Capital Investment Advisors in
Sandy Springs, Ga. “You should look at the fund’s current premium or discount versus its history.” If an appealing closed-end fund has traded at an NAV discount ranging from 5% to 25%, for example, buying at a 20% discount offers more opportunity to benefit from a shrinking discount but buying that fund at a 10% discount may present more exposure to loss from discount widening.
For instance, the closed-end China Fund recently traded at a 10.5% discount to NAV, near the widest point (13.76%) of its discount range for the last five years. Buying stocks at a discount is often attractive, as any dividend is increased. Moreover, buying on the wide side of the discount range may lead to eventually selling when the discount is smaller: as recently as 2013, the China Fund’s discount to NAV was less than 5%.
'LAYER OF COMPLEXITY'
Moss, whose new book is You Can Retire Sooner Than You Think, describes himself as a “huge” believer in buying closed-end funds at the right time; his involvement in these funds, however, is limited to fixed income vehicles.
“There’s probably more volatility on the stock side,” he says, “and that applies to single-country closed-ends. Not only can the stock prices move, the movements in premiums and discounts to NAV can be magnified with equity funds. Assessing the fundamental value of a single-country fund can be difficult, and the NAV premiums or discounts of a closed-end fund add another layer of complexity. If we wanted access to a single-country fund for a more aggressive portfolio, we would use an ETF.”
Donald Jay Korn is a Financial Planning contributing writer in New York. He also writes regularly for On Wall Street.