Bigger Discount Now, Lesser One Later--Why?

Seasonally speaking, there’s a good reason to consider closed-end mutual funds now.

According to a recent Morgan Stanley Dean Witter study, closed-end fund share prices tend to trade at their widest discounts to underlying net asset value in the last few weeks of the calendar year. Those discounts then tend to narrow dramatically by mid-January.

Although the study focused on closed-end funds that invest in stocks of individual countries, analysts say the same dynamics hold true for many types of closed-end funds.

What causes the fund discounts to shrink?

Morgan Stanley closed-end fund analyst Paul Mazzilli, the author of the study, said much can be attributed to traditional end-of-the-year tax-related selling.

Toward the end of a calendar year, fund investors tend to sell some of their under-performing funds to lock in losses. Those losses can be used to offset capital gains for tax purposes.

Meanwhile, investors also tend to put off new purchases of mutual funds at the end of the year for fear of being hit immediately with taxable gains, which tend to be distributed by funds at this time of year.

Notes Mazzilli: For closed-end funds, “what drives [the] discounts and premiums is supply and demand.” And at this time of year, demand can wane. Hence discounts tend to widen.

But once the capital gains distribution season is over, investors often jump back into mutual funds with vigor. And closed-end fund share prices often climb closer to what the portfolios are truly worth.

Of course, there’s no guarantee that a closed-end fund’s discount will disappear altogether--or that it won’t widen again by spring. Indeed, closed-end funds have historically tended to trade at discounts to their net asset values, in part because of investors’ preference for open-end funds that invest in similar assets.

That has led some activist investors to push for the merger or liquidation of some closed-end funds, as a way to eradicate the discount--and realize the true value in the fund. Over the last three years, 33 closed-end funds have liquidated, merged with another, or “opened up,” meaning they converted into open-end funds, according to fund research firm CDA/Wiesenberger.