The Subject Is Closed-End Funds : They’re Being Overlooked, but Some Analysts Think That’s About to Change

When you look at what’s happening with closed-end stock funds, it’s hard to believe there’s a bull market in progress.

Closed-end funds have been wallflowers at this party. They are being overlooked by investors, as evidenced by the persistently wide discounts at which they sell. And they’re being ignored by fund companies, which have stopped bringing new products to market.

Yet such signs of scorn may lay the seeds for good opportunities down the road. Some analysts believe it’s only a matter of time before closed-end funds move back into the limelight.

Several factors explain why closed-end portfolios have been pushed to the side by mutual funds, which are enjoying robust cash inflows. For starters, they’re more complicated.

“The buying public doesn’t under stand the closed-end structure,” says Tony Maltese, a Smith Barney managing director in New York.

The share price of a regular mutual fund, formally known as an “open-end” portfolio, directly reflects fluctuations in its stock or bond holdings, less expenses. If stock prices rise, so will the fund’s price.

But closed-end portfolios work a bit differently. They trade like stocks, at prices that don’t necessarily mirror their underlying assets. Closed-end funds sometimes fetch premium prices, but discounts are more common.

At the end of September, a whopping 83% of closed-end funds were trading at discounts, reports Lipper Analytical Services in Summit, N.J.

Among stock portfolios, the average markdown was 13.6%, meaning that investors essentially could pick up a dollar’s worth of assets for about 86 cents. Of course, the shares can’t be sold for a dollar currently.

The prevalence of discounts is near the highest levels since the Persian Gulf crisis, says Don Cassidy, a senior research analyst in the Denver office of Lipper Analytical.

Normally, investors would be attracted to such discounts like flies to honey, especially at a time like the present when bargains are scarce. But investors aren’t interested now, perhaps because the prevalence of discounts during a bull market is confusing them.

“When they see a fund trading at a discount, many people conclude that something must be wrong, so they sell their shares,” says Maltese. “This creates a vicious cycle.”

But purchasing a fund with a rather large discount actually helps to dampen risk, he adds. If anything, the time to buy is when a portfolio trades at a markdown, not at a premium.

However, there is still a risk. “A big discount looks great, but there is no guarantee it just won’t keep getting bigger,” says Dave Garrison, senior analyst for closed-end funds at CDA Wiesenberger Inc., a financial research firm. “If it’s a dog fund in a dog sector, it may never come back.”

Other factors that help explain the relative unpopularity of closed-end funds include the following:

* Investment companies tend to spend more advertising dollars to support open-end funds. Closed-end products stay roughly the same size over time, whereas mutual funds can grow indefinitely. So there’s more money to be made from rising management fees on the latter.

* Mutual funds, but not their closed-end cousins, are commonly used as investment options in 401(k) accounts and other workplace retirement plans. The explosive growth in these plans has helped to fuel the expansion of mutual funds.

* A large percentage of closed-end portfolios target foreign stock markets, which have lagged U.S. returns during the 1990s. Closed-end vehicles are well-suited to invest in the types of illiquid stocks found in many foreign nations, but they won’t sparkle until these markets shine again.

Despite the drawbacks, some investors might not realize that discounts on closed-end funds frequently narrow and sometimes even turn into premiums. This creates a profitable scenario for investors--doubly so if the underlying stock or bond prices also are rising.

Ron Santangelo, manager of mutual fund research for Merrill Lynch in New York, thinks closed-end funds might now be near a popularity low point. “We see a reversal of the premium-discount trend in the next three years,” he says. “It tends to go in a three-year cycle.”

Maltese also thinks bargains are available, as does Cassidy at Lipper Analytical, who especially likes the prospects for international funds.

“With foreign markets [lagging] and discounts wide, you have a convincing case for contrarians,” he says.

Another thing that mainstream fund investors might not realize is that closed-end funds actually are easier to manage than comparable open-end funds, which can enhance their returns over time.

Because the portfolios stay roughly stable in size, managers don’t have to worry about putting sudden inflows of shareholder cash to work at times when stock prices are high. Nor must they worry about selling stocks to raise cash to meet shareholder redemptions during market retreats.

Ignoring the premium-discount effect, “closed-end funds actually have outperformed open-end funds because they don’t have to worry about redemptions or cash flows and can stay fully invested,” says Santangelo.

Overall, investors need to be cautious.

“This is a complex investment vehicle, where every attribute can be a positive or a negative,” says A. Michael Lipper of Lipper Analytical. “Someone may feel very comfortable with mutual funds, but closed-end funds are different. If you don’t understand--and I mean really understand--how it works, then you shouldn’t be investing in a closed-end fund.”

Russ Wiles is a financial writer for the Arizona Republic.