Retail Goods at Wholesale Prices - close-end mutual funds

Kiplinger's Personal Finance Magazine, May, 1999 by Steven T. Goldberg

These closed-end funds sell for less than they are worth.

Investing in closed-end funds is a little like playing chess: It's an acquired taste, rather than something you take to right away. And while there are a few rules to learn, once you have mastered the game, the pleasures--and, more important, the profits-can be enormous.

The universe of closed-end funds includes funds in out-of-favor sectors (and sometimes even in hot sectors) that are on sale for much less than the underlying value (called the net asset value, or NAV) of the securities they own. You'll find high-quality tax-exempt bond funds that currently yield almost 6%---a percentage point or so more than you can earn on ordinary high-quality municipal-bond mutual funds.

Closed-end funds are a cross between regular mutual funds and stocks. Their managers invest in a portfolio of securities and trade them when they can grab better ones--just as managers of other funds do. But a closed-end fund typically issues shares just once, when it first begins operations. Those shares then trade like stocks.

So the law of supply and demand reigns, and closed-end funds often change hands at substantial premiums or discounts to their real net asset values. Fidelity Advisor Emerging Asia (symbol FAE, New York Stock Exchange, share price $9), for instance, holds securities worth about $70 million. But the fund trades at a 12% discount to its NAV, meaning the market is pricing its holdings at just $62 million. That's largely because investors worry that the mostly small Asian nations where the fund invests aren't yet out of the economic woods. In short, Emerging Asia offers a way to buy $1 worth of stock for 88 cents.

Buying assets at a discount can pay off in more ways than one. In the past few years, institutional investors have bought big stakes in funds trading at substantial discounts. They have then lobbied, sometimes successfully, to get the funds to convert to ordinary mutual funds (often called open-end funds).

Fidelity Advisor Emerging Asia recently announced that it will almost certainly convert, probably in the summer or fall, to an open-end fund. That would give investors a one-time 14% profit. If you sell your shares within six months after the conversion, Fidelity will charge you a fee of up to 4%. And if Asian stocks plunge, you could even end up with a loss. But the 12% discount puts the odds in your favor. Scudder New Europe (NEF, NYSE, $20) offers a similar opportunity. It's selling at a 9% discount but plans to merge into an open-end Kemper fund.

On occasion, the discounts and premiums on closed-end funds can defy all logic. For example, Malaysia fund, which lost almost half its NAV in the past 12 months, nevertheless sold at an astonishing 38% premium to NAV in February. At the same time, investors bullish on Malaysia could have bought Webs Malaysia (EWM, American Stock Exchange, $4), an index of Malaysian stocks trading at a discount to its NAV. Most closed-end funds that invest in Japan also trade at fat premiums, although open-end Japan funds are plentiful. Says Al Fredman, a finance professor at Cal State University at Fullerton: "It's irrational."

In addition to converting, closed-end funds have come up with a variety of other strategies to narrow discounts. Among them are share buybacks and plans that allow some investors to cash out at NAV. The most successful method has been to guarantee a quarterly distribution of at least 2.5% in capital gains and dividends to shareholders-even though, if the fund doesn't do well, some of that money may be just a return of the money you originally invested. These techniques, coupled with today's robust stock and bond markets, are making it harder than usual to find huge discounts.

BEYOND DISCOUNTS

It's not just discounts that make closed-end funds so intriguing. One of the biggest advantages of closed-end funds is that they don't have to deal with the waves of new cash that often swamp top-performing open-end funds. Nor do they have to keep assets in cash for fear that investors will redeem shares en masse.

That is especially significant when a fund invests in a thinly traded corner of the market. For instance, Royce Micro Cap (OTCM, Nasdaq, $8) buys stocks with a market value (stock price times number of shares outstanding) of $150 million, on average. Such stocks don't trade much. The fund has beaten its identically named open-end clone every year but one since its inception in late 1993.

Because closed-end funds are so stable, many bond funds borrow money to increase their investments in bonds. Van Kampen Municipal Opportunity II (VOT, NYSE, $14), for instance, has $175 million in assets. It then borrows another $60 million in short-term loans (which are tax exempt to the lender) at a current rate of about 3%. The fund then invests the $60 million in long-term bonds.

As long as long-term municipal bonds yield more than short-term muni bonds, which is most of the time, the fund makes money on the transaction. But leveraging a portfolio this way makes a fund vulnerable when interest rates rise. For instance, the Van Kampen fund's NAV was clobbered for a 16.2% loss in 1994, when rates soared. Moreover, panicked shareholders sold the fund, widening its discount five percentage points and causing the market price of the fund to plunge 21.2%.