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YOUR MONEY : Why Closed-End Funds Have Taken a Beating

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RUSS WILES, <i> a financial writer for the Arizona Republic, specializes in mutual funds</i>

It’s clearance time along the closed-end fund aisle.

These investments, near cousins to regular mutual funds, have had a forgettable first half of 1994.

Part of the problem is that a large number of closed-end funds focus on emerging global stock markets or municipal bonds--two popular areas that have been hit hard this year. The fact that many of the bond portfolios leverage or borrow against their holdings has made things worse.

But while the slump in closed-end funds has proved painful for existing shareholders, it has also squeezed much of the speculation out of the market and created many bargains for new buyers, advisers say.

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“There are some tremendous buying opportunities,” says Peter Madlem, editor of Frank Cappiello’s Closed-End Fund Digest, a newsletter in Santa Barbara.

Closed-end funds, like regular mutual funds, are professionally managed portfolios that hold dozens of individual stocks or bonds, usually of a similar type.

But while the price of a mutual fund will rise or fall in direct relation to the value of its holdings, the price of a closed-end portfolio can fluctuate above or below that amount--to where the fund is said to be trading at a premium or discount. This feature adds another element of risk for investors, because premiums can vanish and discounts can widen.

In retrospect, many closed-end funds were downright expensive at the start of the year. Since then, they have gotten cheaper, mostly because their portfolio holdings have depreciated. Some funds have also seen their premiums contract or their discounts widen--a second way to lose.

Especially hard hit have been certain foreign closed-end funds that invest in the companies of developing nations. The price of the Turkish Investment Fund plunged 53% during the first six months of this year, on the heels of a 169% surge in 1993.

Several Latin American and Asian funds have lost 25% or more in 1994 after strong showings last year.

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“The Pacific Rim nations, excluding Japan, have been slaughtered,” says Colin Mathews, a closed-end fund analyst with Morningstar Inc. in Chicago.

Thomas J. Herzfeld, a Miami investment adviser who specializes in the closed-end area, observes that many of the funds that have fallen the most this year were the ones that traded at the highest premiums in 1993.

“Now many of these funds are trading at reasonable valuations again,” Herzfeld says.

Some of these purchases include portfolios that own shares in German, Spanish, Mexican, Thai and Philippine stocks. Madlem says his newsletter also likes certain funds that invest in Germany, Spain and Mexico, along with funds in Korea, Pakistan and India.

Since many foreign closed-end products focus on the stocks of a single nation, it’s good to diversify among at least a few funds.

Closed-end bond funds have been falling this year for somewhat different reasons. They got pinched by higher interest rates--which erode the value of all bond investments--and by their widespread use of leverage.

Unlike the vast majority of regular mutual funds, a significant number of the tax-free closed-end funds utilize borrowed money as a way to boost returns. The strategy works well during periods of flat or falling interest rates, but it has boomeranged so far this year.

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Most closed-end muni funds leverage their holdings--to a maximum of $1 in borrowed money for every $3 in assets, Mathews says. Some muni funds are off more than 10% this year, excluding dividends.

Some muni funds are selling at discounts near 10%.

A 10% discount on a closed-end fund essentially allows investors to buy a dollar’s worth of stocks or bonds for 90 cents. The rub is that the same portfolio could drop to perhaps a 15% discount next week.

But Madlem and Herzfeld, who publishes his own closed-end investment newsletter, see bargains in the muni area these days.

And both say there are attractive buys among “term trusts”--special government bond funds that liquidate in a predetermined year, typically in the late 1990s or early 2000s.

Ronald Reuss, chief economist for brokerage Piper Jaffray in Minneapolis, predicts municipal closed-end funds will rebound, because he believes interest rates will stabilize and because he expects demand for tax-free bonds to grow as supplies decline.

Most closed-end muni funds have dropped in value this year, which has helped boost their leveraged, tax-free yields. For example, California muni funds are paying 6.75% yields on average, says Madlem, with some selling at discounts in excess of 5%.

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Compared to regular mutual funds, closed-end funds on the whole are more complex and risky. They’re also less convenient--each trade must be made through a stockbroker (with a resulting commission cost), and small subsequent investments aren’t cost-efficient. Mathews says interested beginners should consider using some closed-end products to round out their portfolios of regular mutual funds, rather than the other way around.

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