Closed End Funds: Bruised But BeckoningJeffrey M. Laderman
The market has no mercy. If the past year was rough on mutual funds, consider the plight of the closed-end funds. Not only did their portfolios buckle under the weight of rising interest rates but investors dumped them by the bushel. Closed-end fund investors have to sell their shares on the open market instead of requesting the fund company to redeem them. And as they sold out, share prices dropped much farther than the underlying value of their investments: Equity funds saw their portfolio returns drop by 4.6%, while share prices fell 12.5%. Bond funds, with a 3.9% loss in portfolio return, took an even bigger hit--14.9%.
The good news about the 1994 pasting is that closed-end funds are now more attractive than they have been in years. That bargain-counter pricing even extends to some of the funds that earned three upward-pointing arrows--the highest rating for risk-adjusted returns in the BUSINESS WEEK Closed-End Scoreboard.
PITFALLS. Because there are so many more opportunities, we have expanded the Scoreboard to cover 260 closed-end funds, 35 more than last year. The Scoreboard, which is prepared for BUSINESS WEEK by Morningstar Inc., reports one- and three-year returns, by both the change in net asset value (NAV) and by share-price performance in the market. Ratings calculations are based on three-year NAV returns. In most cases, investors will want to buy funds at discount to NAV. That's why the Scoreboard reports how much higher or lower a fund is trading compared with its NAV.
Start your fund-hunting with those selling at a discount. But watch out. The funds with the largest discounts aren't necessarily the best buys. "You still have to apply all the scrutiny that you would for a mutual fund," says Catherine Gillis, editor of Morningstar Closed-End Funds, a publication that reports on the closed-end universe. "For instance," she notes, "is the fund well managed?"
A case in point is Engex. This closed-end equity fund invests in emerging growth companies and sells at a 29.3% discount to NAV--the largest discount in the Scoreboard. But that fund is no bargain. Engex' portfolio management has produced a three-year average annual return of -6.6%. That's worse than all but one equity mutual fund in BUSINESS WEEK's Mutual Fund Scoreboard (Feb. 6).
Bargain hunters may also salivate over discounts in many single-country and emerging-markets funds. Back in 1993, international funds had phenomenal returns--an average 52% NAV gain and 72% in share-price gains. But be wary of jumping in too quickly. "These funds are attractive, but they're not at giveaway prices yet," warns Thomas J. Herzfeld, the dean of closed-end fund investing.
SHORT STORM? Some are way overpriced even after the bloodletting. Just look at the Mexico, Emerging Mexico, and Mexico Equity & Income funds. Even after a 35% collapse in the peso and a 12% fall in stocks, the funds sell at prices significantly higher than their net asset values. A lot of investors, it seems, are trying to ride out what they think is a short-term storm. But if the damage turns out to be more long-lasting, those share prices will follow those much diminished NAVs downward. If you're looking to bottom-fish for stocks south of the border, Herzfeld suggests sticking to more diversified regional funds such as the Latin America Equity Fund.
But even buying a fund at an attractive discount does an investor no good if the underlying market is in a funk. "The premium/discount issue is overdone," warns Rory S. Costello, closed-end fund analyst for Prudential Securities Inc. "It's more important to be right on the market." One of Costello's top picks is First Australia Fund, which sells at a 10.8% discount to NAV. "People are bullish on commodities, and this fund has some heavy bets on commodity producers," he says. Costello also recommends the relatively staid New Germany and Swiss Helvetia funds rather than betting on a rebound in the volatile Third World funds.
Opportunities abound among the bond funds as well. Herzfeld, in particular, thinks there's good value among the "term trusts," the closed-end funds that liquidate within several years. Many of these trusts invested in mortgage derivatives to generate high yields, and their prices collapsed in last year's bear market. "Many will not make their objective of redeeming at $10 a share," says Herzfeld. "But the term trusts are cheap and the discounts large, so you can still make money."
After the worst bond market in six decades, term trusts are a little too risky for most gun-shy analysts to recommend. They're generally advising investors to stick with funds that invest in short to intermediate maturities and have good credit quality. They also warn against funds with exotic mortgage-backed securities and leverage. Many closed-end bond funds borrow on margin or issue preferred stocks to buy more bonds than their asset size would otherwise permit. Morningstar's Gillis says Allmerica Securities, Pacific American Income Shares, and USLife Income funds all fit the "plain-vanilla" bill--and sell at discounts to NAV to boot.
On the municipal-bond side, caution is the watchword, too. "The funds with the biggest discounts are those with the lowest coupon bonds and the longest maturities," warns Mariana F. Bush, an analyst for Kemper Securities Inc. "Those funds may not be right for conservative investors who buy funds for income."
However, if you want to make a bet on falling interest rates, funds with lower yields and the longest maturities are the ideal maneuver. If rates do fall, their NAVs will rise and their discounts will narrow--and investors will make a double score. You can find these funds--as well as the more cautious sorts--in the Scoreboard that starts next page.