Closed End Funds: Upstaging A Down Market
Every wallflower eventually gets to dance. Closed-end funds stood on the sidelines for years, snubbed by investors. Although they advertised a choice selection of stocks at cut-rate prices, who wanted to save money buying lackluster returns?
That's all changed. Closed-end funds, which trade like stocks, ran circles around the overall market. Two factors were at play: The underlying assets held by closed-end funds gained ground, while savvy investors bid up the prices of closed-ends even more. The numbers tell the story: The net asset value (NAV) of U.S. closed-end equity funds gained a neat 7.3% on average last year, but share prices rose 11.2%, according to the Kansas City (Mo.)-based Closed-End Fund Assn. Compare that with the 9.1% drop in the Standard & Poor's 500-stock index last year. Closed-end funds also clobbered their bigger brothers, conventional open-ended mutual funds that are bought and sold at NAV, which lost 3.5% on average last year. And closed-end municipal bonds, up an impressive 16.7%, beat open-end muni-bond funds, up 11.1%. Last year's jump-start has helped performance so far in 2001. On average, equity closed-end funds are up 8.2% year to date, Lipper Inc. reports, though some funds are up even more.
PREMIUMS. First, a closed-end primer. These investments act like stocks because a fixed number of shares trade on an exchange, mainly the New York Stock Exchange. But because they have an underlying portfolio of stocks and bonds, they also act like mutual funds, with NAVs that roll with the market. When the share price is below its NAV, which it often is, closed-end funds are said to sell for a discount.
The result of renewed demand is that discounts, which have in some cases persisted for years, are falling. The 16% discount of the average domestic equity closed-end fund's share price to its NAV has been lopped in half since last March. In a handful of taxable bond funds, the discounts have been wiped out; some have even turned into premiums, as high as 30%, in the past several weeks because investors expect the underlying bonds to rally. On an improving stock market, the Bancroft Convertible Fund is up 11.44% as its 15.4% discount fell to a current 10%. The discount for the Nuveen Municipal Market Opportunity Fund has been whittled down to 4% from 10% and its share price rose 6.4%.
Do the closed-end funds have it in them to turn in a solid performance again this year? The key is to figure out what will happen to a particular portfolio of stocks or bonds and what will happen to that all-important discount. Will it continue to narrow, or will it revert to more historic levels?
Before the recent turnaround, discounts had been running at record highs. Of 518 closed-end funds, 350 continue to trade below net asset value, although the spreads are narrowing. That spells ongoing opportunity, particularly for bond-fund investors: Closed-end bond funds pay higher yields because the interest on the bonds is based on the share's lower NAV, not the market price. For example, the yield on the bond portfolio is 8%, but because the fund sells at a 10% discount, the yield jumps to 8.88%. "Closed-end funds are little-loved, but there's no other place to get these yields," says John D. Maier, director of equity research for UBS Warburg. The discounts in single-country and foreign funds have, however, persisted as both overseas economies and currencies have weakened. The average country fund sells at a discount of 19.6%, though some are higher yet. The Templeton Dragon Fund, a fund that invests in the China region, sells for a 27% discount. Analysts don't expect those discounts to narrow overnight.
"RISK-AVERSE." Investors are discovering that closed-end funds can outperform conventional mutual funds in down markets. When the market sours, closed-end managers aren't forced to liquidate holdings to meet redemptions. William Fitzgerald, managing director for Nuveen Investment Management, points out that when equity-obsessed shareholders redeemed some $13 billion from open-ended muni funds last year, managers had to carry huge cash balances. Since the yield on cash is far less than the yield on munis, returns suffered. Also, unlike open-end bond funds, closed-ends leverage their assets to buy more bonds. That explains how some have recently sparkled, as the cost of borrowing has fallen along with interest rates. By the end of the year, share prices were further boosted by investors seeking safer investments. "Many investors have become risk-averse and have moved out of stocks into cash," says Fitzgerald, whose firm will add 13 new closed-end funds to its roster of 64 this year in anticipation of a surge in demand. "It's entirely possible that investors will look to these funds as a substitute for cash."
When it comes to equity closed-end funds, prolonged outperformance ultimately depends on "good stock-picking," says Paul J. Mazzilli, a Morgan Stanley Dean Witter closed-end analyst. Of the 17 funds Mazelli covers, 14 outpaced the S&P 500 for the past three years. General American Investors, which trounced the S&P by 21% last year, is on average 18.6% ahead of the index for three years running. Adams Express Co.'s three-year return has outdone the S&P by more than 7.5%. The nice part is that investors have owned the likes of Cisco, General Electric, Wal-Mart, and Enron in these funds at a discount, while still earning healthy annual dividends.
If you're considering buying a conventional open-ended fund, you might check out a look-alike closed-end fund instead. The $1.9 billion Invesco Health Sciences fund saw a 25.8% return in 2000. Not bad, but the net asset value of the closed-end $607 million Invesco Global Health Sciences Fund gained 32%, even though it's run by the same manager, John R. Schroer. (He left Invesco earlier this month to start his own hedge fund.) More than that, investors bid up the share prices of the fund, so they gained a roaring 46.4%.
Closed-ends have an advantage over open-end funds when it comes to management fees. On average, closed-end equity funds have expense ratios that are about a half-percentage point less than open-end funds with similar categories, reports Mazzilli. With the stock market no longer delivering double-digit returns, those fees start to add up. And the difference is especially significant when it comes to bond funds.
As word gets out, discounts will keep narrowing. But don't expect instant gratification, warns Curt Weil of Weil Capital Management in Palo Alto, Calif. "They offer a way to buy assets cheaply, but they require patience" for the discount to narrow and make your return, he says. "Sometimes it has taken years." The $3.5 billion Tri-Continental fund, which invests in blue chips such as GE, Microsoft, and Intel, has traded at a premium for just two weeks since '96. Its three-year average discount in a market favoring large caps was about 18%. Those numbers don't add up for Daniel Roe, a principal with Budros & Ruhlin Inc. in Columbus, Ohio. "Would we like to buy these companies at 85 cents on the dollar? Absolutely, if we can sell them for their full value," he says. "Otherwise, there is no bargain."
There are other risks with closed-end funds. While leverage has amplified returns, it could exaggerate losses in the future. "Risky strategies help them move to the top of the charts," says Gregg Wolper, senior analyst with Chicago's Morningstar Inc. "But they can run into deeper problems when markets turn against them." Leveraged closed-end bond funds, for example, tanked in 1994 worse than open-ended bond funds as higher interest rates ate into dividend yields and increased the cost of borrowing.
It's not easy to keep in step with the market. But now that the tempo for closed-end funds has picked up, it looks like a good time to give them a whirl.