Are you open to closed-end funds?

They're bit players in the mutual fund world, but they can shine with profits—even when the market is volatile.

By Leslie Kane
Senior Editor

Sometimes it pays to follow the less-traveled path. That's how those in the know feel about closed-end funds, which resemble mutual funds but have key differences. Despite the miserable domestic stock market, some closed-end funds have brought fabulous returns this year. Thai Capital Fund boasted a year-to-date return of 10.7 percent through Nov. 15. ACM Government Opportunity Fund returned 13.0 percent, and Aberdeen Asia-Pacific Income Fund 21.2 percent. "Closed-end funds have unique features that create an opportunity to outperform traditional mutual funds," says Brian Smith, CEO of the Closed End Fund Association in Kansas City, MO. "They're a bit more sophisticated and contain more elements than mutual funds, but if you're willing to learn about them, you can do well and use them to diversify your portfolio."

Don't confuse closed-end funds with closed funds, which are traditional mutual funds that no longer accept new investors. The name reflects the differences in the way the fund shares are issued, bought, and sold. Closed-end funds issue shares only once, at their inception. Investors can trade the shares like stocks, on an exchange such as the New York Stock Exchange or Nasdaq.

This means investors can buy closed-end fund shares only when a new fund starts up or when another shareholder wants to sell his shares. In contrast, traditional "open-end" mutual funds create new shares as more investors buy into the fund. Shareholders buy and sell directly to the fund, even when using a broker.

Another difference between closed- and open-end funds involves pricing. When you buy shares of a traditional fund, you pay the net asset value (NAV)—the fund's total net assets divided by the number of shares outstanding. But closed-end fund shares are typically bought at a percentage above or below the NAV, that is, at either a premium or a discount.

Investor demand primarily dictates price changes, and ultimately, investor profits. Naturally, when the fund's performance is stellar, demand is likely to rise, and vice versa.

Overall market conditions and sector demand also affect the price—and currently, conditions favor closed-end funds, says Smith. For one thing, when the market drops, closed-end fund managers don't have to liquidate investments and abandon their strategies to deal with redemption issues, as open-end fund managers do. That's because for every seller of a closed-end fund share, there has to be a buyer; investors can't just stampede out en masse when the market gets dicey.

"In fact, closed-end funds stand to do well in volatile markets," Smith adds, "because that's when brokers and advisers look to them to find values in the discounted funds, trying to make up for losses in the overall market."

Nevertheless, not all closed-end funds have profited over the past two years; some have sunk right along with the market. Like any investment, closed-ends have drawbacks as well as benefits, and you need to understand those before you consider investing.

More than one way to make a profit

One benefit closed-end funds offer is the potential to make money if the net asset value stays the same. For example, say a fund's NAV is $30 a share, but shares are trading at a 20 percent discount. Each share would cost $24. If the discount narrows to 10 percent, the share price rises to 27, even though the NAV hasn't changed.

You can profit the other way around, too: If the NAV rises to 40 but the discount stays the same, the share price increases to 32. Or you can gain through a combination of the two.

Because the total number of outstanding shares remains constant, closed-end funds have a more stable pool of investable cash than open-end funds. That allows them a broader range of investment choices and the ability to make long-term bets, which can give them a profit edge over open-end funds.

"Closed-end funds also can borrow significant amounts and buy investments on margin," says Smith. Such leveraging can increase investors' effective yield, but leveraging is either limited or forbidden in mutual funds.

"If a closed-end fund has $100 million in assets, it can borrow $50 million," says Mariana F. Bush, a closed-end fund analyst with First Union Securities in Washington, DC. "The manager can borrow at 5 percent and invest that money at 8 percent, to give shareholders a 9.5 percent yield."

If you buy a closed-end fund at a discount to NAV, your effective yield increases. Let's say a closed-end fund has an NAV of $10 and is trading at a 20 percent discount, for a price of $8. If the dividend is $1 but you've only put in $8 to buy the fund, your effective yield is 12.5 percent. If you'd paid the full NAV, the yield would be just 10 percent.

This yield advantage makes closed-end income funds extra tempting now. Some top ones worth looking into are Aberdeen Global Income, Strategic Global Income Fund, and Templeton Global Income Fund (see "Top closed-end funds").

The extra risks of closed-end funds

Although extra freedom in choosing investments increases profit potential, it also has a flip side. "The portfolio manager can invest in more illiquid and riskier securities and markets," says Smith.

A large number of closed-end equity funds invest in a single country or region, such as Korea or Latin America. But individual markets can be volatile. Funds that invest in them aren't well diversified, either, which adds to their risk.

"Closed-end funds are also a little harder to understand; they have more moving parts," adds Bush. That's partly why they have yet to catch on with mainstream investors. Another reason: There are only about 630 closed-end funds, compared with more than 7,000 open-end ones. Moreover, if the stock market falls, they could potentially fare worse than mutual funds. If a closed-end fund's NAV drops with the market and the discount deepens because investors are fleeing, the fund takes a double hit.

Unloading closed-end fund shares could prove tough, too, since you can sell only if there's an interested buyer. If other shareholders are also selling, you may be unable to do so, or you may have to sell at a large discount.

What can you do to limit the risks? First, buy at a discount rather than a premium, and—unless the fund owns a lot of risky investments or has a poor performance record—the deeper the discount, the better. Consider paying a premium only when the fund's performance has been sterling and it appears that it's still picking up steam.

Also look at the direction of the discount's movement over the past year before making the purchase. "If the discount has begun to narrow, it may be a good time to purchase the fund," says Smith. A narrowing discount means the fund's desirability is on the upswing, and the discount may even rise to become a premium—a good time to sell.

Before investing in any single-country fund, you'd also want to research the country's political situation and economic prospects, which could wreak havoc on the fund's performance.

To find information about closed-end funds, ask your financial adviser, or check the Web site at the Closed End Fund Center ( www.closed-endfunds.com). Some brokerages include a section for closed-end funds on their Web sites. One that does is Charles Schwab & Co. (www.schwab.com ) (Click on Investment Choices, Mutual Funds, then EFTs/REITs). You can also track closed-end funds through Morningstar, an investment research and analysis company (www.morningstar.com).

"Closed-end funds are a good bet for long-term investors interested in adding an income component to their portfolio, or a longer-term equity investment such as a single country fund, " says Smith. He suggests investing 10 or 15 percent of your portfolio in closed-end funds to help diversify it. "Because they're a little more complicated, the average investor is probably better off buying these through a registered professional," he adds.

Top closed-end funds

These are among the top 25 closed-end performers based on year-to-date return, according to Morningstar, a mutual fund research and analysis company in Chicago.

Market total return*

Ticker symbol

Year-to-date

3 years (annualized)

Premium or discount to NAV

Equity Funds

Central Fund of Canada

Indonesia

Southern Africa

Templeton China World

Templeton Dragon

Income Funds

Aberdeen Asia-Pacific Income

Aberdeen Global Income

ACM Income

Strategic Global Income

Templeton Global Income

*As of Nov. 15, 2002. All funds trade on the NYSE, except for the Central Fund of Canada, which trades on the AMEX and the Toronto Stock Exchange (TSE), and Aberdeen Asia Pacific Income, which trades on AMEX and the Pacific Stock Exchange (PSE).

 

Leslie Kane. Are you open to closed-end funds?. Medical Economics 2002;24:49.