Where The Small Investor Is KingJeffrey M. Laderman
America's financial markets are the most efficient in the world. But there's one corner where pockets of inefficiency still exist, where big institutions rarely invest, and where individuals can still buy $1 worth of assets for 90 : closed-end funds.
That's why we are expanding theBUSINESS WEEK Mutual Fund Scoreboard to cover 105 closed-end equity funds and 120 closed-end bond funds. In these pages, you'll find a wealth of data on fund objectives, fees, and their one- and three-year average annual returns. And for the first time, we're rating the closed-end funds (table). The proprietary ratings, based on risk-adjusted portfolio returns for the last three years, were prepared by Morningstar Inc.
Closed-end funds are the oddball cousins to mutual funds. Like mutual funds, closed-ends are professionally managed portfolios of securities run for a specific objective, like income or to invest in European stocks. Their portfolios can be analyzed the same way as mutual funds.
That's where the similarity ends. For starters, the average closed-end equity fund has woefully underperformed the average open-end. That's because the closed-end equity universe is dominated by foreign funds, and foreign markets have trailed the U. S. stock market.
But the most crucial difference between closed-end and mutual funds is that closed-ends trade like stocks. Investors who want to buy or sell closed-end shares go to a stockbroker, because the shares trade either on a stock exchange or in the over-the-counter market.
NAV-IGATING. This feature is what gives rise to inefficiencies--and opportunities. A fund's share price is determined by market forces--the actions of buyers and sellers--not necessarily the value of the fund's holdings. When the price of the fund's shares exceeds its net asset value (NAV)--the per-share price of its portfolio--the fund is said to be at a premium. When the fund shares trade at less than NAV, it's at a discount. The best strategy is to buy at a discount. As of Feb. 12, 59 equity funds and 38 bond funds were at discounts.
Investors should not buy a closed-end fund, no matter how attractive the past returns on its portfolio, if it is trading at a large premium to its NAV. That puts Bergstrom Capital, one of four closed-end equity funds to earn three upward-pointing arrows, off-limits--at least, until its 25% premium shrinks considerably. Buying Bergstrom now means paying $1.25 for every $1 worth of stocks--hardly a smart deal. Still, a well-managed closed-end fund, such as Bergstrom, General American Investors, or Source Capital, might be worth a small, single-digit premium, says Catherine Gillis, editor of Morningstar Closed-End Funds. "Think of it like paying a load on an open-end mutual fund," she says. But she says today's best buys are in European funds, since those stocks have long trailed U. S. stocks and not surprisingly, many of the funds are at discounts.
Premiums and discounts on bond funds don't usually reach the extremes seen in equity funds. Still, buying at any premium could be dangerous. Dreyfus Municipal Income and Dreyfus Strategic Municipals, the only top-rated tax-exempt funds, were launched in a period of higher interest rates and thus have many high-coupon bonds that could be subject to call. If that happens, the premium will evaporate.
DIVERSITY PAYS. Keep in mind, too, that many closed-end bond funds use leverage. They issue preferred stock or borrow from brokers to purchase more bonds. As long as the cost of the preferred dividends or the borrowings is less than income produced by these additional bonds, the fundholders win. That's why the NAV total returns of closed-end bond funds beat those of conventional bond funds 10.7% vs. 8.1% during 1992, and 10.7% vs. 9.6% per year for the 1990-92 period.
Leverage is great when rates are falling, but it can be dangerous if rates rise. That's why Gillis is wary of leveraged funds and suggests that bond-fund buyers look to "multisector" funds--bond funds that spread their money among U. S. government, international, and corporate issues. She likes the diversification and still finds some discounts among those funds.
You can find all the closed-end funds, with the latest information on premiums and discounts, in the Scoreboard that starts on page 98.