If you own a bond mutual fund, most likely it’s an open-end version that holds an
assortment of municipal, government, or corporate notes. The price you paid for your
shares was equal to the value of your portion of the bonds in the portfolio. And at the end of any trading day, you can redeem your shares by selling them back to the fund. But these funds often charge as much as 5.75% for their initial purchase. What if there was a way to buy a similar portfolio at a discount? You could then possibly end up with a higher yield on your investment.

Closed-end funds have a fixed number of shares and trade on the exchanges, just like
stocks. The result, however, is two prices for its shares: a Net Asset Value (NAV) price
and a market price. The NAV is based on the actual value of the bonds in the portfolio,
just like it is for an open-end fund. Conversely, the market price constantly fluctuates throughout the day and depends on changes in investor sentiment.

The NAV of the closed-end fund will vary with daily fluctuations in bond prices, just as the price of a stock fluctuates due to changes in supply and demand. Buyers and sellers might push the market price up or down in an emotional response to a changing NAV. This presents an opportunity for investors, because the market price could possibly be lower than the NAV in some cases. Of course, it can also be higher.

As with all investments, closed-end bond funds do not come without risks. They normally trade below their NAV and there is no guarantee that closed-end funds will trade at or above that level. Some funds are also riskier than others. For example, a given fund may employ leverage to achieve certain objectives, which entails additional risk. While this strategy has the ability to magnify yields, it also exposes the shares to increased volatility and can cut into your return if short-term rates rise quickly. Other funds may purchase foreign securities or low-grade issues, which increases their risk of sustaining losses from default. Therefore, you should not base your buying decision on yield alone. The quality of the issuers in the portfolio is also a major factor to consider, as well as the fund’s historical performance and management philosophy. But closed-end funds can be purchased for the same price as a stock or other individual security, and their greater liquidity and lower price are much more attractive for short-term traders and investors than open-end funds with their high sales charges.

When the economy is in the midst of a major downturn, many investors will immediately conclude that their funds are under-performing. However, before making this blanket assessment, there are several factors that you should take into account. If your fund has declined in value enough to worry you, then it’s time to ask yourself some key questions.

1. Is This Fund Appropriate for You?
A fund that has returned 11% over a given period may seem “better” than a fund that has returned 3% over the same period, but the better-performing fund may have earned those returns by taking on certain market related risks that you might not want to assume. Investment objectives will vary widely among investors, so you need to consider whether the fund fits your time horizon and investment objective.

2. How is this fund performing relative to other funds in its peer group?
Different asset classes, such as stocks and bonds, will perform differently because they have different risks. The value of a stock fund will tend to be sensitive to equity market fluctuations, while bond fund values will respond more to interest rate movements. So before concluding that your stock or bond fund is underperforming relative to one of its peers, be sure that you’re comparing apples to apples.

3. How is the fund performing relative to its appropriate benchmark?
Virtually all mutual funds impose certain requirements that limit the investment options of the portfolio managers. For example, if the investment policy statement of a given stock fund requires that at least 80% of its portfolio assets to be invested in stocks, the portfolio manager will not be able to allocate more than 20% of assets to bonds or cash, even in a bear market. Therefore a reasonable standard for measuring mutual fund performance might be to consider how the fund’s performance compares to the overall performance of an appropriate index (meaning one that matches the subcategory of the fund as closely as possible). If your fund consists of bonds, it obviously makes no sense to compare it to the Dow Jones Industrial Average. There are several classes of stock funds, such as small-caps and international funds for which the Dow is probably not an appropriate comparison.

4. Are there any specific extenuating circumstances to explain the under-performance?
There could be any number of reasons why your fund’s short-term performance may not be particularly meaningful, especially if the economy as a whole has experienced a decline in production. For example, you may have bought a fund that has performed poorly in the past, but you also believe that a new management team will turn this around in the near future. This factor is particularly important to remember after a decade like the 1990’s, where rising annual returns were achieved by many funds. In view of this, you might want to consider whether your expectations are realistic. Before you cash-in your “under-performing” shares, you may want to determine the factors that are driving the performance of your funds.