An Open Secret: Closed End Funds

The bulls seem to stampede down Wall Street every day, taking the stock market to new highs. They're galloping through the bond market, too. But there's one dark corner untouched by the thundering herd: U.S. closed-end funds. They're trading at bear-market valuations, making them some of the best bargains in the investment bazaar.

Closed-end funds' problem is not their portfolios. The value of their holdings has surged this year. But closed-ends have a fixed number of shares that trade like stocks. That means, unlike mutual funds, they can change hands at prices far different from their net asset values (NAVs). When a fund trades at a price in excess of NAV, it's at a premium; when the price is below NAV, it's at a discount. In bull markets, investors bid up the shares: Discounts narrow and sometimes become premiums.

The bulls have held sway for the past six months, yet they have had no impact on discounts. Bond-fund discounts are little changed from the bear-market bottom. Equity discounts have actually widened (chart). The reason? Investors haven't shaken off 1994. That's when share prices for equity funds fell an average of 12.5%, even though NAVs lost less than half that amount. Bond-fund prices plunged 14.9%, vs. a 3.9% portfolio loss. "There's just no investor interest," sighs Thomas J. Herzfeld, whose Miami investment firm specializes in closed-ends.

When buyers are scarce is just the time bargains are bountiful (table). "These funds are about as out of favor as you can get, and many are historically very cheap," says Colin Mathews, an analyst for Morningstar Closed-End Funds. In buying closed-ends at a large discount, investors can win two ways if the markets rise: one from the gains in the underlying portfolio and the other from the improvement in share price.

It also helps to look for a catalyst that can eliminate the discount. For instance, the Jundt Growth Fund, at a 7.7% discount, plans to convert into a mutual fund, which will wipe out the discount. Analysts also like the Charles Allmon Trust, a fund with a mediocre track record and a 15.3% discount. Portfolio manager Allmon is retiring and will likely be replaced by Liberty Asset Management Co. Liberty also runs Liberty All-Star Equity Fund, which now sells at a 5.6% discount but often trades at a slight premium.

A cut in the capital-gains tax would help vintage funds such as Baker Fentress, TriContinental, and Salomon Brothers. All own stocks bought for a fraction of their current value and have huge unrealized gains. "One reason these funds sell at discounts is that buyers are factoring a tax liability," says Herzfeld. With a lesser tax bite, discounts should narrow.

"FLAT TAX" TALK. There's opportunity among the bond funds, too. Muni funds have been under pressure as "flat tax" talk sweeps through Washington. By lowering rates, a flat tax would make munis less attractive. Nonetheless, Herzfeld says some funds are irresistible. He bought Van Kampen Merritt California Value Fund at a 20.1% discount, which is even larger than when Orange County filed for bankruptcy.

Fund analyst Robert A. Young of Dean Witter Reynolds Inc. looks for similar funds that have different results, such as BlackRock Strategic Term Trust 2002 and BlackRock Income Trust. The portfolio returns of both funds are around 10% so far this year. Yet Term Trust is up 8.8% in share price and trades at a 13.1% discount, while Income Trust is up more than 14% and sells at a 5.5% discount. "If Income Trust can rally, so can Term Trust," says Young.

To be sure, there's no sure thing in investing. But at current levels, closed-ends come mighty close.

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