Test Water Before Leaping Into Closed-End Fund

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

Now is the time of year when closed-end funds typically sell at their cheapest levels. Potential bargains can abound as investors dump shares to lock in taxable losses, pushing down fund prices to discounts.

For various reasons, you still can lose money even if you buy shares for less than they’re truly worth if the closed-end fund were liquidated. To understand why, it helps to know how discounts arise.

Closed-end funds issue a limited number of shares, which trade in the stock market. Unlike a regular mutual fund, the sponsors of a closed-end portfolio don’t stand ready to buy back shares when investors want to sell. With no organization supporting its price, a closed-end fund will fluctuate according to the whims of the marketplace. Regular mutual funds, by contrast, consistently mirror the values of their portfolio holdings.

Some closed-end funds climb to premium prices, meaning that investors are willing to pay more than a fund’s underlying stock or bond investments are worth.


But most portfolios slide to discounts. In fact, 84% of closed-end funds were trading below their net asset value in October, reports Lipper Analytical Services of Summit, N.J. The NAV is simply the per-share value of a fund’s holdings in stocks, bonds or other investments.

Researcher Morningstar Inc. of Chicago determined that discounts alone aren’t sufficient to protect shareholders from steep price declines.

“On many occasions, this cushion resembled a thin bamboo mat more than a fluffy pillow,” the company observed in a recent report. “Discounts offer less protection than one might hope.”

Ron Santangelo, manager of mutual fund research for Merrill Lynch & Co. in New York, goes so far as to say the size of a discount is somewhere between a secondary factor and an irrelevant factor in predicting performance of closed-end portfolios.

On stock funds, he says, a fund’s asset allocation and the portfolio manager’s skills are much more important. On bond funds, the earnings yield is the dominant factor, Santangelo says. This measures the amount of income spun off by a portfolio, excluding capital gains and any return of principal.


Other closed-end analysts express more enthusiasm for buying funds at discounts, but most quickly add that this number is meaningful only when compared to a fund’s historic discount range and to discounts on competing funds. That is, a 10% discount wouldn’t signal a bargain if the fund normally traded at a 20% markdown, or if rival portfolios did.

Randy LaCombe, a closed-end research analyst for brokerage Piper Jaffray Cos. in Minneapolis, suggests looking at up to five years’ worth of premium or discount information before deciding if a fund’s current markdown represents a bargain.

In addition, he suggests trying to find an explanation for the discount. Many funds sell cheap because the portfolio carries high fees or the management team has done a poor job.

As another red flag, be careful about funds filled with obscure, hard-to-price investments such as “private-placement” mortgage securities or derivative instruments, says LaCombe.

While the final weeks of the year can be a good time to pick up closed-end funds cheaply, investors must beware a tax trap, warns Donald Cassidy, a senior research analyst in Lipper’s Denver office.

Closed-end funds pay capital-gains distributions at this time. People who buy shares shortly before a portfolio’s ex-dividend date would receive the payment, and be subject for taxes on it, even though they didn’t enjoy any corresponding profit.

This danger wouldn’t pertain to people investing inside of individual retirement accounts and other tax-sheltered plans. Nor would it be a problem for investors who delay their purchases until after a fund’s so-called “ex-distribution” date.

While discounts on closed-end funds don’t necessarily herald bargains, in some cases they clearly can translate into pay dirt. For example, if shareholders vote to transform a portfolio into a regular, open-end mutual fund, any discount will eventually disappear.

Yet such votes are fairly rare because “opening up” a fund isn’t always in the best interest of a fund’s management. Converting to regular mutual-fund status could result in a drain of assets and thus fee income for the management company.


Oppenheimer Management Corp. of New York has agreed to purchase the three Rochester, N.Y., bond mutual funds for an undisclosed amount.

Rochester runs two tax-free bond funds and a convertible-bond portfolio that count $2.9 billion in combined assets. The funds’ current managers will become Oppenheimer employees and remain in Rochester.

Oppenheimer counts more than $39 billion in mutual-fund assets.


The Janus 20 Fund has reopened to new investors for the first time since January, 1993. The Denver-based growth portfolio shut its doors after surpassing $3 billion in assets in late 1992. Its high-water mark came in 1991, when it surged 69%, more than double the return of the Standard & Poor’s 500. But the no-load fund ([800] 525-8983) lagged the S&P; 500 in 1992, 1993 and 1994.

Portfolio manager Tom Marsico sticks with a concentrated portfolio of stocks in Janus 20, which counted 52 holdings as of June 30.