Have Closed-End Funds Reached a Dead End?
The stock and bond markets were on fire in 1995, but you couldn’t tell by looking at closed-end funds. Instead of climbing to premium prices--as you might expect during bullish phases--86% of closed-end portfolios now trade at discounts to the value of their holdings of stocks and bonds.
Only five fund groups brought new closed-end products to market in 1995, raising a scant $600 million, reports Lipper Analytical Services of Summit, N.J. A record 125 new funds debuted in 1993, raising $18 billion.
“Owing to the dearth of new offerings, along with the loss of funds that have . . . [converted to open-end status] . . . or merged, the size of the closed-end fund universe has declined for the first time in at least a decade,” writes Gregg Wolper at Morningstar Inc. of Chicago.
Are investors merely catching their breath on closed-end funds after a wave of new issues in the early 1990s, or have they permanently lost their appetite for these investments?
“I’m beginning to believe there is something seriously wrong with closed-end funds,” said Chris Meyer, senior vice president and director of product management at Putnam Investments of Boston, one of the five firms to unveil a new fund in 1995.
The problem, as he and others see it, is that new closed-end funds usually fall to where they’re selling at a discount to their net asset value, the per-share worth of the stocks and bonds held in a portfolio. Discounts naturally upset investors who bought shares at full price when they were first offered, and these complaints filter back to brokers who, understandably, stop recommending the funds.
“When a fund drops to a discount, brokers have a tough time explaining it to their customers,” Meyer said.
Discounts are prevalent because of the way closed-end funds are sold. Broker commissions and other charges are built into the per-share price when shares are offered to the public. These costs add up to roughly 7% of the opening price, which means essentially that investors pay $1 for 93 cents worth of assets.
Fund groups often support the price by repurchasing shares and trying other tactics. “But eventually you have to let them go out on their own,” Meyer said.
Other factors contribute to the lack of enthusiasm for closed-end funds. For instance, the products are a bit harder to understand than regular mutual funds since investors have to keep tabs not just on the NAV but on any premiums and discounts.
“Buying shares at a discount makes sense if the discount narrows,” said John Markese, president of American Assn. of Individual Investors in Chicago. “But a lot of people have a hard time analyzing when that discount will narrow.”
In addition, relatively few professional analysts track closed-end investments, which means not many research reports get written about them, with less investor enthusiasm drummed up in this manner.
Only about a dozen brokerages employ closed-end analysts, said Donald Cassidy, a senior research analyst in Lipper Analytical’s Denver office. That’s not a wide following considering that roughly one in seven companies listed on the New York Stock Exchange is a closed-end fund.
Yet another reason for investor disenchantment involves the types of investments for which closed-end funds are known--bonds as well as the stocks of emerging foreign nations.
Even though 1995 brought welcome relief in terms of lower interest rates, many conservative investors remember getting burned by closed-end bond funds when rates spiked in 1994. Unlike regular bond mutual funds, many of those of the closed-end variety leverage their holdings to boost returns. This strategy enhances yields during favorable interest-rate periods but can backfire otherwise.
As for foreign stocks, many of the emerging markets struggled in 1994 and 1995 following strong rallies in 1993. The performance of emerging markets had been especially dismal compared with the strong gains logged by domestic stocks.
That might be changing, however. Peter von Raits, president and portfolio manager of Closed-End Fund Advisors in Santa Barbara, believes the slump in Third World stocks might finally be over, given strong rallies around the globe so far this month.
Meanwhile, many observers believe that closed-end portfolios offer some compelling bargains compared with regular mutual funds.
“They’re one of the best-kept secrets on Wall Street,” Cassidy said.
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How They Work
Closed-end funds share certain traits with both stocks and regular mutual funds. Here’s a look at their key characteristics.
* Diversification. Closed-end funds typically hold dozens if not hundreds of stocks or bonds, just as regular mutual funds do.
* Share availability. Fund companies sell closed-end shares through public offerings in the stock market, just as regular corporations sell stock. After an offering, closed-end funds trade in the stock market, primarily on the New York Stock Exchange. Regular mutual funds don’t offer shares in this manner. Instead, they stand ready to issue new shares on demand or redeem shares on request.
* Premiums or discounts. The prices of regular mutual funds rise or fall in direction proportion to fluctuations in their stock or bond investments. With closed-end funds, the share price also depends on investor sentiment. When investors are really hot on a closed-end fund, they might bid it to premium prices. Usually, however, closed-end prices fall to a discount below what the portfolio holdings are truly worth.
