The Wide Open Market For Closed End Funds
The bulls stampede through the stock market almost daily. The Dow Jones industrial average hit 12 new highs in the first 14 trading days of November. Investors are pouring billions a month into equity mutual funds. Yet closed-end equity funds are stuck in a veritable bear market.
It's not as though their portfolio managers have missed the market. It's just that these funds, which invest the same way mutual funds do but are bought and sold like stocks, have not risen as fast as the value of their holdings. As a result, they sell at large, double-digit discounts to their net asset values (NAVs). Typically, those discounts shrink to single digits in a bull market or even trade up to premiums as investors bid up fund shares.
Investors should not kiss off closed-end funds, however. Anyone investing in mutual funds ought to check if there's a cheaper alternative among closed-ends. Managers of closed-ends are finally starting to take steps to fight the usually large discounts. Even so, investors will be surprised at the bargains.
"OVERWHELMED." Take the John Hancock Regional Bank Fund, a mutual fund that has been riding the crest of banks' booming earnings and merger mania. The portfolio is up about 26% so far this year--and this load fund has pulled in $900 million in new cash in 1996. Now, consider John Hancock Bank & Thrift Opportunity Fund, its closed-end cousin that trades on the New York Stock Exchange and is run by the same manager. The closed-end's portfolio is also up 26%--yet the market price has risen only 17%. An investor can pick up that fund at a 12% discount.
So why haven't closed-end funds been swept along by the bull market? In part, it's because investors are unfamiliar with these funds. "Closed-ends are overwhelmed by mutual funds," says Edward R. McRedmond, closed-end-fund analyst at A.G. Edwards & Sons Inc. "You can't pick up a paper or magazine without an article on mutual funds, and the returns have been so good that investors haven't felt the need to look elsewhere." In addition, many people don't understand how these funds work, and so they ignore them.
But some experts argue that investors have shunned these funds for more fundamental reasons. "The fund managements have not been running the funds in the shareholders' interests," according to Thomas J. Herzfeld of Thomas J. Herzfeld Advisors Inc., the dean of closed-end investors.
Herzfeld complains that many companies, unable to float new closed-ends, have pressed rights offerings on existing funds. In such offerings, shareholders receive rights to buy newly issued shares in the fund, usually at a discount to the market price. But such offerings are no help to shareholders when market prices are below the NAV. The offerings depress share prices and dilute existing shareholders' holdings.
Many fund boards have also failed to take steps to narrow discounts, such as buying back shares or reorganizing into an open-end mutual fund. Both moves tend to decrease the assets in the fund and, in turn, the fee income the managers can collect.
SIGNS OF CHANGE. That's why Herzfeld likes to invest in funds that must take steps to narrow the discount if it reaches certain preset levels. Schroder Asian Growth Fund is one of his picks. Starting next year, the fund will be required to tender for shares if its discount is greater than 3% for a designated 12-week period. It's now 12.6%.
There are signs that fund companies are starting to take the discounts seriously. John S. Tobey, president of Investment Directions Inc., a consulting firm, is encouraged after a recent industry conference. "In past years, all the fund executives talked about was how to do rights offerings," he says. "This year, they were talking about how to narrow the discounts."
Many fund observers think that better marketing would also help. "They need to hold meetings with analysts and provide more detailed information," says Mariana F. Bush, closed-end-fund analyst at Everen Securities Inc. For instance, closed-ends report their NAVs to the financial press once a week. So on any one day, investors are never really sure where the value of their funds stands compared with the market price. About half the funds now report NAVs daily--Franklin Templeton funds are the latest to start doing it--but they are not in the press. Investors have to call the companies to get the NAV.
Tobey is making a bet on a resurgence in closed-end funds. He recently launched a newsletter, The Closed-End Fund Investor, which recommends funds for purchase. The best time to get into an investment, he says, is when nobody wants it.