It's Still Open Season On Closed End Funds

Bargains can be found, but the discounts have been growing narrower

After the spectacular gains made in the stock and bond markets over the past year, a real bargain is hard to find--unless you shop among the closed-end funds. Many of these quirky funds, which invest like mutual funds but are bought and sold like stocks, have racked up stellar investment results in the past year yet still trade at prices that are discounts to their net asset values (NAV). The closed-end fund market is the last place on Wall Street where you can buy $1 in assets for 90 cents.

Well, maybe 95 cents. There are still bargains among the closed-ends, but they're not as cheap as they were just a few weeks ago. The funds rebounded--NAVs rose, but share prices rose faster--in January, narrowing discounts but certainly not eliminating them.

If you're bargain-hunting in the closed-end mart, remember that buying a fund just because it trades below its NAV is no guarantee of riches. Sometimes discounts get larger, and some funds always seem to trade at a discount. To make a smart choice, you also need to know the fund's NAV returns, the performance of the shares in the market, and the amount of risk the fund takes. That's where BUSINESS WEEK's Mutual Fund Scoreboard for closed-end funds can help.

STRONG START. The scoreboard rates funds based on three-year total NAV return, adjusted for risk. This year, six equity and seven bond funds earned the top rating, three upward-pointing arrows. The ratings and the scoreboard data are prepared by Morningstar Inc., the mutual-fund data company.

As a rule, closed-end fund mavens don't recommend investing in a fund, no matter how good its performance, unless it trades at a discount to its net asset value. In today's market, some of the strongest performers sell at discounts--perhaps a reflection of investor indifference. The Swiss Helvetia Fund, for instance, racked up an impressive 32.2% NAV gain last year, thanks to a bullish equity market and a rising currency. Yet the fund's shares, which trade on the New York Stock Exchange, gained only 20%. During the year, the fund traded at prices that were nearly a 16% discount to NAV--the greatest price-to-NAV gap in six years. So far this year, the discount has narrowed to 10%.

Most closed-end equity funds invest abroad--and nearly all foreign markets trailed the U.S. last year. So it comes as no surprise that the average closed-end equity fund lagged its equity mutual-fund cousin during 1995. But many investment analysts expect foreign markets--and hence, closed-end equity funds--to outperform the U.S. market in '96. They're off to a strong start. Thomas J. Herzfeld, a Miami investment manager who specializes in closed-end funds, says his international-fund portfolio rose 11% in January alone.

The outlook is still bright for closed-end bond funds, even though they had an outstanding 1995. They earned an average 22.1% total return on their portfolios, vs. 16.4% for bond mutual funds. The main reason is that many closed-end funds leverage their portfolios through margin borrowings or issuing preferred stock. That means a fund with $200 million in shareholder money may own perhaps $300 million in bonds. That leverage can be brutal when the bond market tanks, but it pays off in spades when bond prices rise. The leverage works well for yield-seekers, since those extra bonds help funds generate higher yields than their unleveraged kin.

FLAT-TAX FEAR. In a low-interest-rate environment, these funds still make compelling buys. Fund analyst Robert A. Young of Dean Witter Reynolds Inc. says even after the January comeback, leveraged muni funds trade at a hefty 7.5% discount to NAV. Of course, the muni funds are somewhat in the dumps because of the fear that a flat tax will be enacted, wiping out munis' tax advantage and slashing prices until munis yield the same as taxables (BW--Feb. 13).

But if you're not afraid of the flat tax--most experts think it's a long shot--these funds are attractive. Morningstar analyst Gregg Wolper estimates that with a leveraged muni fund, an investor can pick up 0.5% to 1% more yield over a bond mutual fund. One of Young's recommendations is BlackRock Investment Quality Municipal Trust, with a 14.3% discount and a 6.2% yield. That's the equivalent of 9% for an investor in the 31% marginal tax bracket--a pretty good return all by itself. And if the discount narrows, that's just icing on the cake.

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