The end of the year is one of the market's most active periods, and year-end tax-loss selling makes this a great time to scout out some real bargains on closed-end funds.

A study in The Journal of Finance found that many closed-end funds tend to sell off in the last few weeks of the year and then rally in January. The reason for this seasonal behavior is that tax-sensitive investors often sell funds at a loss late in the year to help offset capital gains elsewhere, lightening their overall tax load.

Heavy year-end selling can drag a fund's market share price below its net asset value(NAV) -- the value of the underlying securities in the fund's portfolio. The resulting discount can create an attractive entry opportunity. For example, if a fund is trading at a -20% discount, then you'll only be paying $80 for $100 worth of assets.

Come the start of each new year, the so-called 'January Effect' usually kicks in. Funds that are cast off in the last few weeks of the year may soon look enticing, as tax loss selling will artificially depress share prices and push yields higher. (Share price and yield move inversely.) If history is any guide, then bargain hunters will swoop in during the first few weeks of January, bidding up the share prices of many beaten-up funds.

Some closed-end funds make better candidates for this strategy than others. Municipal bond funds tend to work particularly well because owners of these funds are typically focused on taxes. Thinly traded funds with 50,000 shares or less in average daily trading volume also work well. Low trading volume tends to exaggerate price swings, so when investors flock to the exit doors in the weeks before December 31st, they'll move a small fund far more than they would a larger, more liquid fund.

New funds that were issued earlier in the year also make good prospects for this strategy. New funds are typically issued at a premium to their portfolio value because the initial share price includes a fee to the underwriter. These fees can represent as much as 8% of the fund's net asset value. It usually takes a few months for the share price to back off and move closer to NAV, or even below it.

For instance, a fund may come to market in July at a +5% premium to its NAV, but trade at a discount sharp discount just a few months later in November. If this were the case, we would expect to see that discount widen even further as tax-loss selling drags down the share price prior to the start of the new year.

One caveat to using this technique to profit: If investors hold the assets in taxable brokerage accounts, they may want to time their buying to avoid a year-end tax issue -- capital gains. Most funds make capital gains distributions sometime in November or December, and investors may be tempted to capture this distribution. But once a fund goes ex-distribution, the fund price will drop by about the amount of the payment. So if you bought a fund pre-distribution, you would soon see the share price dip and you would also be on the hook for capital gains taxes. Tax-sensitive investors may wish to avoid the tax bite by buying after a fund goes ex-distribution.

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Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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