Closed-end funds are a quirky lot: They look like mutual funds but are bought and sold like stocks. Depending on market conditions, they trade at prices that are different from the value of their holdings, often at discounts. Typically, the discounts deepen late in the year as shareholders dump their losers to generate tax losses, but the recent selling season turned out to be one of the worst in years -- and the New Year's bounce-back could be much muted or delayed.
Why? A glut of new funds. Over the last year investment banks and fund managers raised an estimated $21 billion in initial public offerings for 46 new funds, many of them copycat products. With underwriting fees of as much as 7%, they're lucrative -- and far more profitable than encouraging a client to buy a similar existing fund that trades at a discount.
Investors who bought fund IPOs are getting hit hard. In one case, the Nuveen Equity Premium & Growth Fund (JPG), which buys stocks and sells options to generate income, launched at $20 a share on Nov. 23 and had fallen to $17.25 by Dec. 30, while the net asset value declined less than 5%. All but two of the funds launched in 2005 are at discounts.
The flip side of this, of course, is that for those buying now, these discounted funds can be profitable. "We make half our profit for the entire year buying [in December] and selling in January and February," says Thomas Herzfeld, who has followed the sector for almost 40 years and whose eponymous firm is devoted to investing in closed-end funds.
Some of the biggest markdowns are in funds that invest in bank loans or dividend stocks or produce income by selling options. Equity funds as a whole are trading at a discount of nearly 11%, according to fund-tracking firm Lipper. (RTRSY) That's the biggest discount in four years. The average bond-fund discount is 7%, the largest in five years. Bond funds are hurting not so much from new issuance as from higher short-term interest rates, which forced the many leveraged funds -- which borrow money to buy additional bonds -- to cut their payouts. With the flat yield curve raising fears of recession, many investors are shunning funds that buy lower-quality issues.
CUTTING THE DISCOUNTS
Those high-yield and bank-loan funds are good places to look for bargains, say closed-end watchers. High-yield funds, trading at slight premiums as recently as September, now have an average discount of 11%, pushing their yields close to double-digits. Herzfeld recommends some of the funds trading at the deepest discounts, such as the Prospect Street High Income Fund (PHY), selling at a 17% discount and yielding almost 9%. The big discounts, he says, can act as a cushion to lessen the blow of any decline in bond prices caused by the slowing economy. Bank-loan funds also carry an average discount of 11%. Most invest in floating-rate loans so that as rates go higher, yields increase. "They're less risky than some people seem to think," says Don Cassidy, a senior research analyst at Lipper.
Herzfeld is keeping an eye on the two dozen funds formerly run by Citigroup's (C) Smith Barney unit that were sold to Legg Mason (LM) on Dec. 1. Institutional shareholders lobbied all year to get the funds to take steps to reduce the discounts, such as buying back shares or making a tender offer, but except in one case, Citi did nothing. Expectations are that Legg Mason will be more shareholder-friendly and give the funds a boost.
The best thing that could happen to fund investors is for Wall Street to stop cranking out the IPOs. "How can you offer a new fund when the old funds are so cheap?" says Mariana Bush, a fund analyst at Wachovia Securities (WB), noting that three deals slated for December were postponed. Maybe investment banks are finally getting the message.
By Aaron Pressman