Despite tumble in Aug., consider closed-end funds

October 14, 2007|By Andrew Leckey | Andrew Leckey,Tribune Media Services

For obvious reasons, receiving a discount is more popular than paying a premium.

Closed-end funds, investments that usually can be purchased at a modest discount, have gained attention this year because those discounts have widened.

There are more than 650 closed-end funds, with a total market capitalization of $300 billion. Some homework is required to understand how they work and determine whether you are getting a deal.

Like many of the more familiar open-end mutual funds, they have actively managed portfolios. But after an initial public offering of a fixed number of shares, the shares of a closed-end fund are traded on an exchange like stocks, with the price set by supply and demand. Managers are not obligated to issue new shares or meet redemption demands from shareholders.

The key for bargain hunters is that the price of closed-end shares is determined by the overall market and can be more or less than the net asset value, or NAV, of the underlying investment portfolio. The difference between the two is the premium or discount when you buy.

"You want to buy a closed-end fund at a discount to its NAV, which is what attracts investors," said Sangeeta Marfatia, a closed-end analyst and director with UBS Wealth Management Research in New York. "But just because it is trading at a discount doesn't always mean it is a good buy."

Determine whether a fund's portfolio has performed well. Consider whether it will continue to pay its dividend, because many investors are looking for monthly income checks, Marfatia said.

"When investors see a big cushion of income from a closed-end fund, they expect its dividend won't be cut, and that's why those funds trade at such big premiums," she said. "However, closed-end funds trading at large premiums can also go down a lot more than funds that are trading at discounts."

In August, a panic in closed-end funds tied to the overall market's trauma led to the price collapse of many. Discounts grew to 20 percent or more. As sentiment shifted, discounts have shrunk to an average of about 6 percent, according to Lipper Inc. Yet many funds remain undervalued.

"Closed-end funds are selling at wide discounts, though narrower than in August," said Thomas J. Herzfeld, chairman and president of Thomas J. Herzfeld & Co. in Miami. "I'd advise investors to look at some of the new-issue closed-end funds, which suffered the worst declines of all."

This year, 35 new-issue closed-end funds have opened, and none is selling above its offering price, he said.

Herzfeld said he would bravely wade into the middle of the nation's debt crisis in search of bargains.

"Look for closed-end funds with large exposure to collateralized debt obligations," Herzfeld said. "I believe that by the end of the year there will be pretty good buying opportunities there."

Investors like closed-end funds for several reasons.

"If I can buy the same assets as are in an open-end fund but at 90 cents on the dollar, that's attractive," said Lipper senior analyst Tom Roseen. "Investors also like closed-end funds because they can be traded on a minute-by-minute basis, unlike open-end funds."

Marfatia recommends these closed-end funds:

In a taxable stock-and-bond fund, Calamos Strategic Total Return, with a recent discount of 12 percent. Half of its assets are stocks, one-third bonds, and the rest are primarily cash. Its largest holdings are AT&T Inc., Johnson & Johnson, Merck & Co., Pfizer Inc. and Washington Mutual Inc. It had a 9 percent market return and an 18 percent NAV return over the past 12 months.

In a pure stock fund, Eaton Vance Tax Advantaged Global Dividend Income, recent discount 10 percent. Top holdings are AT&T, the German utility E.ON AG, the United Kingdom's Scottish and Southern Energy PLC, and French companies Veolia Environnement in business services and Societe Generale in financial services. It had a 22 percent market return and a 29 percent NAV return over the past 12 months.

In a municipal fund, Van Kampen Municipal Trust, recent discount 5 percent, average credit quality "AA." It had a 5 percent market return and a 0.18 percent NAV return over the past 12 months.

Closed-end funds differ from exchange-trade funds, or ETFs, which also trade on stock markets. An ETF has a fixed portfolio and because of that probably trades at NAV.

Closed-end funds are subject to registration and regulation with the Securities and Exchange Commission. Because they come in many varieties, they are subject to different risks, fees and expenses, the SEC cautions. The funds can invest in a greater number of illiquid securities than open-ended mutual funds are permitted to.

The closed-end fund with highest recent premium, Lipper said, was Herzfeld's $22 million Herzfeld Caribbean Basin Fund, trading with a 30 percent premium.

His fund had an 85 percent market return and 34 percent NAV return for the past 12 months. Its 76 stock holdings include Seaboard Corp., Consolidated Water Co., Watsco Inc., Royal Caribbean Cruises Ltd. and Garmin Ltd.

Andrew Leckey writes for Tribune Media Services.

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