Managing Money : Demand Plays Tricky Role in Hot Closed-End Funds

Thousands of investors these days are getting pitched by their brokers to buy shares of a hot-selling investment called closed-end funds. Unfortunately, many investors are buying without fully knowing what they’re doing--and suffering poor initial returns as a result.

Sales of closed-end funds, a form of mutual fund whose shares trade publicly on stock exchanges, have been booming since the October crash. So far this year, 36 new closed-end funds have started with total assets of $13.2 billion, compared to 35 new funds worth $11 billion in all of last year, according to Thomas J. Herzfeld, a Miami investment adviser and leading expert on the funds.

Four came to market just this past Thursday and Friday alone, he notes. The largest initial public offering of any U.S. stock was not from Conrail or General Motors but instead was from a closed-end fund, MFS Intermediate Income Trust, that raised $2 billion last March.

No wonder they’re popular: Most of the new funds invest in bonds offering yields in the 10% to 12% range--the perfect lure for investors still jittery about the stock market. Other funds invest in stocks, and some have beaten the market so far this year.

But while you should consider these funds as part of your portfolio, you will need to exercise a fair amount of care in choosing them--at least more than with conventional mutual funds.

Closed-end funds operate similarly to mutual funds in that they pool investors’ money and invest in an actively managed, diversified portfolio of securities, ranging from risky investments such as foreign stocks to conservative investments such as municipal bonds. Some, with names such as the Korea Fund, Taiwan Fund, Mexico Fund and Brazil Fund, invest in stocks of a single country.

However, closed-end funds differ from mutual funds in one major way: Closed-end funds issue only a fixed number of shares, traded on public stock exchanges like the New York Stock Exchange. Mutual funds, on the other hand, create new shares on demand, which you buy from the fund and sell back, too. The shares of a mutual fund are always priced at the fund’s net asset value per share.

But with a closed-end fund, share prices fluctuate higher or lower than the net asset value per share, depending on investor demand for those shares. If demand is low, shares could trade at a discount below net asset value. For example, Excelsior Income Shares, a closed-end bond fund traded on the NYSE, recently had a net asset value of $16.89 a share, but its shares were trading for only $15, giving it a discount of 11.2%.

On the other hand, some funds subject to high demand trade at premiums above their net asset value. Some premiums run as high as 100% or more, meaning investors are willing to pay $2 for every $1 of assets.

Such fluctuation is one of the key reasons why closed-end funds are attractive. In effect, you can profit three ways. First, if you can buy fund shares at a discount, you get assets more cheaply than if you bought them individually. For bond funds, that in effect raises the dividend yield. Second, if fund managers invest wisely, the net asset value of the portfolio can rise, pushing up the share prices.

And third, if demand for fund shares increase, the discount might narrow or the premium might rise, allowing you to make yet another capital gain.

Herzfeld argues that closed-end funds, if bought at deep discounts of 20% to 25% below net asset value, will outperform conventional mutual funds with similar investment objectives over time. For the first six months of 1988, when the Dow Jones industrial average rose 9.96%, Herzfeld’s closed-end average of 20 large U.S. equity funds gained 15.89% (equity mutual funds also beat the Dow in that period, but with a somewhat smaller 13.68% gain).

Of course, you can also lose money these three ways, too--as investors in many closed-end stock funds found out last October. Not only did net asset values plummet with the crash; discounts actually widened--giving investors a double negative whammy.

Accordingly, buying closed-end funds is more complicated--and potentially more rewarding--than buying conventional mutual funds. Not only must you look for good funds with good management, you also should look for funds whose discounts are likely to fall or whose premiums are likely to rise.

But as if defying logic, thousands of investors do just the opposite. They buy closed-end funds at their initial offerings, when share prices in effect sell at an artificial premium above net asset value. That is because underwriters of the funds--the brokers trying to sell shares to you--take a huge chunk out of fund assets to pay themselves fees and sales commissions. Those fees typically run as high as 6% to 7%. Thus, with a new closed-end fund, you may be paying $1 to get only 93 cents worth of assets.

A few months after those shares have been out on the market, however, they often fall to a discount, in part because demand falls as brokers have less incentive to sell already issued shares, Herzfeld says. Why? Because commissions on already issued shares typically run far lower than 1%.

“The average person gets really hurt with closed-end funds,” says Steve Samuels, a specialist in the funds and a principal at Drake Capital, a Los Angeles brokerage.

As an example of what usually happens to new funds, Herzfeld cites the ACM Government Spectrum Fund, issued in mid-May at $10 but recently trading at $9. With an annual yield of about $1 a year, “You’ve given up approximately a year’s worth of income,” Herzfeld says.

Investors buying initial offerings are hurt further because it takes time for new funds to fully invest their money. Thus you don’t get all your money working for you right away. Also, new funds incur transaction costs to buy their portfolios, along with attorney fees and other charges associated with starting up. All of those work to reduce initial yields.

How, then, should you proceed?

Herzfeld and Samuels offer these tips:

- As a general rule, don’t buy closed-end funds at their initial offerings. Chances are you can find an already existing fund with a similar portfolio selling at a discount.

“Anytime someone calls to sell you a new one, hang up,” Herzfeld says.

- Be wary of funds touting higher-than-market yields. To boost yields and make funds more attractive to unsophisticated investors, fund sponsors may invest in lower-quality securities, such as so-called junk bonds. Just be aware that higher yield usually means higher risk.

- Do your homework. Researching these funds is harder than with mutual funds, but there are several sources you can use. Barron’s newspaper lists discounts and premiums on closed-end funds every week. Historical performance data on bigger funds can be found in your library through such investor services as Standard & Poor’s Stock Reports.

If you are willing to spend the money, you can subscribe to Investor’s Guide to Closed-End Funds, a monthly newsletter published by Miami analyst Herzfeld ($275 a year, $50 for a two-month trial; P.O. Box 161465, Miami, Fla. 33116; 305-271-1900).

- Look for funds with average discounts of 5 percentage points greater than their average discount over the preceding six months, Herzfeld suggests. And don’t buy if the average discount for similar funds is wider, he adds.

With such analysis, Herzfeld advises investors to be wary of closed-end bond funds currently, which he contends are overvalued as a group (possibly because of strong post-crash investor demand and a flood of new issues, which are still trading at premiums). As a group, they are selling on average at a 2% premium, 6 percentage points higher than their historical average, he says.

Herzfeld does, however, recommend some bond funds. They include Excelsior Income Shares, recently trading at an 11.2% discount with a 7.5% yield (low because its portfolio is relatively short-term). He also likes John Hancock Income Securities, with a recent 4.4% discount and 10.6% yield, and Nuveen Municipal Income Fund, with a recent 2.6% discount and 8% tax-free yield.

Among equity funds, Herzfeld likes Schaefer Value Trust, which invests in undervalued large capitalization stocks (17.87% discount, 20% total return for the first six months of 1988); Financial News Composite Index Fund, which invests in blue chip stocks approximating the Dow Jones industrial average (19% discount, down 5.9% the first six months), and First Financial Fund, which owns regional bank stocks and thrifts (17.32% discount, up 27.48% the first six months).

For those willing to take higher risks, Herzfeld likes the Mexico Fund and the Brazil Fund. The Mexico Fund has been trading at about a 31% discount, depressed in part due to investor concern about the recent elections. But it’s volatile, with the stock price ranging between $3.625 and $7.50 so far this year.

The Brazil Fund, also highly volatile, recently traded at a 20% discount amid high negative sentiment toward that nation’s stock market. Herzfeld also likes the Asia Pacific Fund, which invests in stocks in Singapore, Hong Kong and other Asian markets. Its shares are trading at nearly a 21% discount.

Bill Sing welcomes readers’ comments but regrets that he cannot respond individually to letters. Write to Bill Sing, Personal Finance, Los Angeles Times, Times Mirror Square, Los Angeles, Calif. 90053.