An Open Invitation To Closed End FundsAmey Stone
As investors comb the globe for ways to tap into emerging markets, they repeatedly hear names such as Mexico Fund, Thai Fund, or Korean Investment Fund. These are not ordinary mutual funds. They're closed-end funds, which share many similarities with the more familiar variety but also have unique properties.
Closed-end funds have a fixed number of shares that trade on stock exchanges. Because the capital stays constant, closed-end funds are ideal vehicles for the thinly traded and illiquid--but increasingly popular--emerging markets. If these funds were set up as open-ends, and if a foreign market took a dive, managers would have a hard time redeeming the shares of fleeing investors.
"YOU GET HOOKED." Once people understand closed-end funds, they tend to become enamored of them. "These are arguably the best investment vehicles on the planet," says George Foot, partner at Newgate Management Associates in New York, which manages portfolios using closed-end funds. Once you catch on, "you get hooked," says Thomas Herzfeld, the author of several books on closed-end-fund investing and president of Thomas J. Herzfeld & Co., an investment advisory firm in Miami. But like a lot of investments these days, these funds have been picked over. While you can still root around for good deals, there are things to watch out for.
Wall Street is heavily promoting a flood of new funds. There were 101 introduced last year and 92 this year through mid-November. But the worst time to invest in a closed-end is during the initial public offering (IPO). Many existing funds are also raising money through "rights offerings," or invitations to existing owners to buy new shares. But critics consider this practice abusive to shareholders because it dilutes the value of their holdings.
Closed-end funds can usually be bought at a discount to the value of the underlying securities. This heightens their appeal, since investors can make money from a rise in the share price as well as from appreciation in the investments. Of course, prices can tumble rapidly because many closed-end funds are small, with less than $100 million in capital. "They can be blown around the pond like a paper sailboat by any kind of breeze," says Foot. You can even lose money on a fund that is appreciating, says Foot. For example, the Japan OTC Equity Fund traded at a 41% premium in July, 1992. Since then, the fund's assets have grown 35%, but the share price--the figure that really matters to investors--has fallen 10%.
Many closed-end funds are now trading at a lower-than-usual discount or even at a premium. The Herzfeld Closed-End Average tracks 18 funds that invest mainly in U.S. stocks. The average discount for those funds has narrowed from -16.6 in 1987 to -4.7 currently. So by jumping in now, "you may be taking on a fair degree of price risk," says Colin Mathews, a closed-end analyst at Morningstar. He compares buying a fund at a premium to picking a stock with a high price-to-earnings ratio.
At least the difference in structure allows for more stable management of closed-end funds than open-end funds. If the stock market suddenly declines, closed-end funds won't be plagued with redemptions and forced to sell holdings to raise cash. "Closed-end funds will go down, too," says David Schachter, president of Limited Supply Securities in New York. "But hopefully, the manager will not have to cash in his chips like the open-end guys."
Conversely, in a bull market, closed-end fund managers don't face the struggle to invest a mass inflow of cash from new investors. Closed-end funds can often get an edge over traditional mutual funds because they don't have to maintain cash to cover redemptions. Plus, only closed-end funds can use leverage, which makes them riskier but enables them to generate higher returns.
MORE THAN SKILL. If you are interested in trying a closed-end fund, choose carefully. "The investor has to make a two-pronged analysis," says Herzfeld. "What are the prospects for the fund's portfolio? What are the prospects for the share price?" To judge the portfolio, look for the same qualities that you would look for in any fund: capable management, an investment strategy that fits in with your objectives, and low fees. But evaluating how the share price might move takes more skill. A good time to buy is when the fund is trading near its largest discount or smallest premium, Herzfeld advises.
Closed-end fund investors debate what you should weigh more heavily--portfolio management or discount. Basically, if you are planning to buy and hold, a strategy that Schachter favors, first look at the underlying portfolio and investment strategy. But Herzfeld says investors are missing out on potential gains if they hold on to a fund, ignoring movements in the share price. "They are excellent trading vehicles," he says. "To overlook that is just shortsighted."
Experts caution against buying during an IPO. But the price often drops and becomes attractive just after the underwriters withdraw support, usually six to eight weeks later. For example, the new Global Small-Cap fund is now selling at a 6% premium, but Foot expects it to reach a 10% discount.
You can also try following the list of funds that are having rights offerings. Existing shareholders should either participate or sell the fund then, since the value of their shares will be diluted. If you are interested in getting into a fund, the discount tends to be widest during the final day or two of the offering, says Herzfeld. The Malaysia Fund, for example, has just finished up a rights offering and is now selling at about a 4% discount, says Foot. This risky but dynamic fund is up 46.8% based on share price through Nov. 12.
December is often the best time to buy because many people sell off their holdings for tax benefits. Closed-end funds also participate in the so-called January effect, which gives a lift to stocks at the beginning of the year. "You want to be a buyer in December and a seller in January," says Herzfeld. "In fact, a significant portion of our profits are made by doing that."
HORSE'S MOUTH. To get information on rights offerings and IPOs, you will have to do some research. Major brokerage firms offer free reports on closed-end funds, but they may not cover the one you are interested in. Schachter says investors should get the prospectus and annual report directly from the company. He provides a free brochure listing the phone numbers for every fund (212 935-1100). He has also set up a free automated quote service for equity and country funds on the same line.
Several newsletters are available, including The Investor's Guide to Closed-End Funds from Herzfeld ($325 a year, 800 854-3863) and Frank Cappiello's Closed-End Fund Digest ($200 a year, 800 282-2335). Both will provide a free sample. Morningstar publishes comprehensive ratings in its biweekly Closed-End Funds, ($195 a year, 800 876-5005). Herzfeld's Guide to Closed-End Funds, a 450-page paperback, provides a more thorough introduction to the group as well as data on individual funds (McGraw-Hill, $22.95).
An easier point of entry to the closed-end world, says Stuart Goldberg, manager of mutual-fund research at Merrill Lynch, is to start with an open-end fund that you like, then check to see whether there is a closed-end version selling at an attractive discount. In a reverse example, John Templeton, chairman emeritus of Templeton Funds, sold his shares of Templeton Emerging Markets, a closed-end fund, at a premium of about 30% to buy the virtually identical open-end fund, Templeton Developing Markets, at net asset value last summer. But Goldberg says closed-end funds are really at their best when they supply access to a product or a market that you couldn't find anywhere else.
A LOOK AT CLOSED-END EQUITY FUNDS FUND DISCOUNT/PREMIUM 1993 TOTAL 3-YR. AVG. TO NET ASSET VALUE RETURN* ANNUAL RETURN* (Nov. 12, 1993) (through Oct. 31) (through Sept. 30) ADAMS EXPRESS -7.7 -2.12 19.56 CHARLES ALLMON TRUST -7.0 1.28 7.73 ROYCE VALUE TRUST -3.38 12.65 27.43 TEMPLETON EMERGING MARKETS 17.1 54.78 39.40 MEXICO FUND -5.9 14.52 39.31 THAI FUND -11.1 24 32.22 CLOSED-END FUND AVERAGE -4.7 4.9 NA *Based on share price, including reinvested dividends and capital gains NA= Not available DATA: THOMAS J. HERZFELD & CO., MORNINGSTAR INC.THE RIGHT TIME TO BUY -- When the fund is trading near its largest discount or its smallest premium -- At the end of the year, when people sell holdings for tax reasons -- When the underwriters stop promoting a new fund offering, usually six to eight weeks after it is introduced -- Just before the expiration of a rights offering, which dilutes the value of shares -- After some bad international news knocks down the price of foreign funds DATA: BUSINESS WEEK