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Should You Open Up to Closed-End Funds?

During bear markets, gaping discounts between closed-end-fund share prices and the value of their stock holdings tend to narrow, cushioning investors against some of the falls. Last year was no exception: Funds specializing in U.S. shares gained an average 6.5% even though their underlying assets lost 1.6% in value, according to the Closed-End Fund Assn., based in Kansas City, Mo. That was a much better performance than the Standard & Poor's 500-stock index, which lost 13%.

Closed-ends act like stocks because a fixed number of shares trade on an exchange, such as the New York Stock Exchange. But their underlying portfolio of stocks or bonds make them look like mutual funds, with net asset values (NAVs) calculated from the market value of their holdings. When the share price is above its NAV, closed-end funds are said to sell for a premium. With discounts, the opposite is true. So if the fund's asset value per share is $20 and it's trading on the market for $18, the discount is 10%.

Why the discount? "Because they're inefficient; nobody knows about them," says analyst Kevin McNally of Salomon Smith Barney. Discounts and premiums are good guideposts to closed-end funds. Naturally, a consistent outperformer can trade at a premium. But for the most part, paying above a fund's NAV isn't a good idea, while heavily discounted funds often deserve their rock-bottom prices. For example, the Equus II fund has traded at a 31% discount for five years because many investors are leery of its penchant for leveraged buyouts and startups.

The moral is to buy funds in an asset class that makes sense; otherwise, discount or no, the investment isn't a bargain. If you are a bold contrarian and think growth is set for a comeback, you might go for one of the handful of growth closed-end funds, such as the Bergstrom Capital fund, which sports a discount of 9%. But if you're still wedded to value plays, there's less choice because few U.S. value funds still trade at a discount. One that does: the small-cap Royce Value Trust Fund, managed by veteran value manager Charles Royce. It has a 9.5% discount even though the fund's shares gained 15.8% last year and its NAV rose 20.6%.

Is there still serious money to be made in closed-ends? At first blush, the answer is yes. More than half of the 524 funds tracked by Lipper still trade below their NAV, including many bond funds. The trouble is, say pros, those with the most potential for superior gains are mostly specialists in the sectors investors love least: emerging-market, foreign, and growth stocks. "But if you know what you're doing, you can make unbelievable money," says McNally.

The best buys right now require taking on some risk. Posting some of the largest losses last year was the international-markets group, down an average 3.9%, while NAV fell 9.3%, reports the Closed-End Fund Assn. Losses and discounts narrowed sharply from 2000, when shares and NAV lost 23.5% and 22.2%, respectively. Analysts say global and emerging-market funds could move toward premiums and be good places to park some money. It has happened before: When investors soured on emerging markets in 1998, closed-end foreign funds were trading at large discounts--some over 30%. But after the market rebounded the next year, those same funds sold at double-digit premiums as share prices jumped 54.9% and portfolio values gained 58.2%. Share prices and NAV for Asia-only funds rose 63.7% and 69.5%, respectively.

Closed-end bond funds are another way to play the international market. In general, discounted closed-end bond funds have an extra edge: They pay higher yields than open-end bond funds. That's because the interest on the bonds is based on the share's lower NAV, not the market price. The yield on the underlying bond portfolio may be 8%, but because the fund sells at a 10% discount, its effective yield jumps to 8.88%. For example, Morgan Stanley Dean Witter's Emerging Market Debt Fund, which invests in government and corporate debt, sells at a 8.6% discount, which boosts the underlying yield of 11.4% to nearly 12.5%.

Funds that invest in U.S. bonds are trickier to assess. Because the bond market has rallied, discounts and the potential for returns have fallen, so tread lightly. Paul Mazzilli, director of closed-end funds at Morgan Stanley, recommends focusing on sectors that could do well as the economy recovers. He's bullish on mortgage funds, such as Blackrock Income Trust, which has a decent 5% discount and a 7.6% yield. The 3.9% discount on ACM Income Fund looks attractive as well. It yields 10.4% mainly because it invests in emerging- and global-market debt as well as U.S. government debt.

Leveraged municipal funds that borrow to juice performance can offer attractive yields, too. Although they rose 12% last year, they still have an average tax-free yield of 6.25%, a full percentage point more than 10-year taxable Treasuries. Even moderate Fed tightening this year will have a negligible impact on yields, says William Fitzgerald, a managing director at John Nuveen, who oversees $32 billion in muni closed-end assets. "Investors have been hedging against risk in the equities markets by moving into money market funds," he says. "But municipal closed-end funds are much more effective."

The one sector that is severely overvalued is high-yield. On average, high-yield funds trade at 18.4% premiums, though some are as high as 35.7%. These funds have rallied in anticipation of a rebound after two years in the tank. But even if high-yield bonds do recover this year, closed-end funds are unlikely to share in the spoils since they're already overvalued. Investing in diversified high-yield funds that buy abroad might be a better bet. Despite its 24.6% premium, Salomon Brothers High Income is a possibility. It has a third of its assets in emerging-market debt--and it's consistent, having beaten most of its peers since its January, 1993, launch.

Another way to buy high-yield debt without paying a high premium and exposing yourself to volatile price swings is through multisector funds. They diversify into government and corporate debt and tend to avoid borrowing. MFS MultiMarket Income Trust, with a yield of 7.8% and a discount of 5.1%, or Putnam Premier Income Trust, which sells at a 4% discount and yields 8.7%, are options.

Making good returns in closed-end funds by betting on a narrowing of discounts depends on a rebound in their sector or in the economy. But unlike smart buys in the stock market, bargains in closed-end funds are clearly marked as early-bird specials. By Mara Der Hovanesian

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