A Bargain Hunter's Guide To Closed End Funds

Our newest Scoreboard spots portfolios trading at a discount

If it were a conventional mutual fund, Korean Investment Fund would have been one of 1998's top performers: Its net asset value (NAV) soared 85.3%. But anyone who owned this closed-end fund would have been disappointed. Closed-ends trade like stocks, and last year, shares in this fund rose just 11.8%.

Unlike mutual funds, where investors always buy and sell at the net asset value of the fund's holdings, closed-end funds trade on the stock exchanges, where investment sentiment and portfolio behavior sometimes part ways. A year ago, Korean Investment traded at a 33% premium over its NAV even though the portfolio had been decimated by the Asian crisis. As Korean Investment's NAV recovered in 1998, the share prices moved little, so the premium disappeared and actually turned into a discount, which is now 10.7%.

SITE SELECTIONS. But that's where the opportunity lies. Closed-end funds can be bargains, giving investors a shot at buying a portfolio at a discount to its underlying value. That's why we're bringing you the closed-end fund version of the BUSINESS WEEK Mutual Fund Scoreboard.

Our survey measures performance by net asset value and market price. We also grade these funds from "A" to "F" based on three-year NAV returns, adjusted for risk. Nine equity and 25 bond funds earned A's (table). Starting on page 96, we carry data for 120 equity funds and 70 bond funds. At www.businessweek.com, you will find those in addition to 264 more bond funds.

Overshadowed by mutual funds, some closed-ends are trying to improve their visibility. About 20% now report NAVs daily through various--but not all--stock-quote services. To get an NAV, bracket the fund's ticker symbol with X's. So while EFI will get you a market price for the Europe Fund, XEFIX gets yesterday's NAV. Closed-ends usually report NAVs only on Fridays.

Why bother with closed-ends when there are so many mutual funds? Look at A-rated Hancock Bank & Thrift Opportunity Fund, which trades at a 13% discount. Gregg Wolper, closed-end analyst at Morningstar Inc., says the fund is a clone of Hancock Regional Bank Fund B, which of course sells at NAV--and has a 2% expense ratio. The closed-end fund's expenses are 1.45%. Wolper says others with look-alike mutual funds include Gabelli Equity, Invesco Global Health Sciences, Royce Value, and just about all the municipal-bond funds.

Many closed-end bond funds, both taxable and tax-exempt, have higher yields than their conventional bond-fund brethren. That's because they can borrow to buy a larger portfolio than their assets would otherwise support. That's not risk-free--a jump in rates would hurt the NAVs of leveraged funds more than it would those of regular bond funds.

Closed-end expert Thomas J. Herzfeld says municipal bond funds are particularly attractive, because many new closed-end funds have been launched in the past month, driving down the prices of existing funds. The result, he says, "is that many muni funds have higher yields than Treasuries." Herzfeld, whose Miami-based Thomas J. Herzfeld Advisors Inc. manages the portfolios of closed-ends, says the best time to buy them is near the end of the month, when they tend to sell off. Herzfeld says prices usually rally in the first days of the next month.

DOUBLE-EDGED. If you buy these funds at a discount, you'd better be prepared to own them at a discount as well. By NAV return, top-rated General American Investors beat the Standard & Poor's 500-stock index over the past 1, 3, and 10 years. But it has not traded at or above its NAV since early 1993. Some funds, often under pressure from shareholders, take steps to narrow or eliminate the discount, the most extreme being converting to an open-end format. On Jan. 28, the directors of Scudder New Europe proposed just that. Despite a 34.9% NAV return last year, the fund traded at discounts between 13.7% and 27.3%.

Funds can change stripes in other ways. A large shareholder recently wrested control of top-rated Preferred Income Management, which invests mainly in preferred stocks, and plans to invest instead for long-term capital gains. That's why analyst Kevin McNally of Salomon Smith Barney decided to put the fund on the firm's "avoid" list. He expects the dividend to be severely cut or eliminated, leading yield-conscious shareholders to dump the fund's shares.

As with any investment, track record is only a starting point. But you can't make a smart investment without that first step, which begins with the Scoreboard on page 96.