TCS Daily


Closed Encounters of the Good Kind

By James K. Glassman - November 21, 2003 12:00 AM

Unscrupulous mutual funds, as investors have learned to their chagrin, have found plenty of ways to cheat. There are, however, sound alternatives with many of the benefits of mutual funds but without the drawbacks. I discussed one such investment -- exchange-traded funds (ETFs) -- a few weeks ago. Now, consider closed-end funds.

Like mutual funds, ETFs and closed-ends are portfolios of assets -- stocks, bonds or a combination. But, unlike mutual funds, ETFs and closed-end funds trade continually, as long as the markets are open, with prices fluctuating according to supply and demand.

In every case, the recently discovered mutual-fund abuses involved large investors profiting at the expense of small ones by exploiting the fact that most mutual funds are priced only once a day --- at 4 p.m. Eastern time.

Closed-ends have another advantage over mutual funds: A closed-end manager has a fixed amount of cash to invest, which is raised when the fund launches its initial public offering. Investors in a closed-end who want to sell shares offer them on the New York or American stock exchange or the Nasdaq Stock Market. The sale has no effect on the fund's portfolio of stocks or bonds.

In contrast, when investors want to sell shares in a mutual fund, the shares are "redeemed" -- or turned into cash -- by the fund itself. If too many investors demand cash at the same time from a mutual fund (a problem that has recently arisen for some of the funds implicated in the scandals), the fund may have to sell assets to meet the obligation; that is, the manager may be forced to dump stocks he wants to keep at prices that are too low. When that happens, the fund's remaining shareholders can suffer.

What's the difference between an ETF and a closed-end?

An ETF is an investment company that has a portfolio that tries to mimic a specific index. For example, Standard & Poor's Depositary Receipts, or Spiders (symbol: SPY) reflect the S&P 500, which comprises the largest U.S. stocks, while iShares Goldman Sachs Technology Index (IGM) reflects a popular tech gauge.

A closed-end fund is also a portfolio that trades on a stock exchange, but it's not based on an index. It's run by a real person.

There's another, technical, difference that has significant consequences. Because of some clever financial engineering, shares of an ETF decrease and increase in a way that keeps the price of those shares linked closely with the underlying index. In other words, the price is rarely at a significant premium or discount to the index's net asset value (NAV). When you buy an ETF, you get the index, plain and simple.

Shares of closed-ends often trade at prices that are different from the NAV of the stocks they own. In other words, if you add up the stock-market value of all the stocks in the portfolio of a closed-end and then divide the result by the number of shares outstanding, you can get a number that is substantially different from the stock price of the closed-end fund itself.

Since World War II, closed-ends have generally sold for less than the market value of their holdings; that is, at a discount. The median has fluctuated between a premium of 5 percent of NAV and a discount of 25 percent.

Why? Economists haven't found a definitive answer. They call the anomaly the "closed-end puzzle." But the result is clear: Closed-ends carry an element of risk that's absent from mutual funds and ETFs. For example, in July, ACM Income (ACG), a closed-end fund that owns a portfolio of government bonds, carried a 10 percent premium. Investors then began to grow less enthusiastic, and the premium turned into a 2 percent discount. So, even though the value of the assets within the fund (the NAV) rose, the price of the fund dropped from $8.73 to $8.17 -- a loss of 6 percent.

Probably the best answer to the closed-end puzzle was offered in 1989 in a paper authored by a distinguished cast of economists that included J. Bradford DeLong, Andrei Shleifer and Lawrence H. Summers, the former Treasury secretary who is now president of Harvard University. They argued that closed-ends vary from their NAVs because of an "irrational investor sentiment factor." For example, in the third quarter of 1929, the fervor for stocks drove the premiums for closed-ends up to an average of 50 percent.

Concerns about investor sentiment impose "an additional source of risk on holdings of closed-end funds that investors must be compensated for bearing," DeLong and Shleifer wrote in a later paper. "In other words, closed-ends must on average sell at a discount to their net asset values, which is indeed the case."

In order to pay you to take the extra risk, closed-ends are cheaper than the stocks they own. Weird, but logical.

For example, Tri-Continental Corp. (TY), a 74-year-old closed-end investment company that owns a bundle of blue-chip stocks, last week traded at a discount of 15 percent. In other words, you can buy $10,000 worth of equity assets for about $8,500. That sounds like a great deal -- until you realize that, when you sell the stock in a year or two, you will probably have to suffer a similar discount, which over the past 10 years has averaged 14.6 percent.

One way that closed-ends try to narrow, or eliminate, their discounts is by providing regular income to their shareholders by passing on capital gains from the sale of shares and dividends generated by the stocks they own. For example, Gabelli Equity (GAB), managed by the firm headed by Mario J. Gabelli, over the past eight years has paid an average of $1 per share to its owners. Last year, that payout amounted to about 15 percent of the fund's price.

Discounts and premiums of all closed-ends are calculated and posted on the Web site www.closed-endfunds.com, which offers lots of other information as well. Morningstar (www.morningstar.com) is another good source for information on closed-ends.

Tri-Continental is the largest closed-end fund, with total assets of $2.1 billion. It carries an expense ratio of 0.68 percent. That compares with expenses of about 1.5 percent for the average stock mutual fund and about 0.25 percent for the average ETF. But don't forget that with both closed-ends and ETFs, you have to pay brokerage fees to buy and sell. Say you buy $5,000 worth of Tri-Continental and your broker charges you $30 for the transaction. That's another 0.6 percent in expenses. If you own the shares for a long time, the overall effect of the brokerage commission diminishes, but, still, you shouldn't expect a typical closed-end to have costs much lower than an inexpensive mutual fund.

The advantages lie elsewhere -- in protection against timing abuses and in the lack of redemption pressure. In addition, many closed-ends have solid portfolios, with good stock selection and low turnover.

Consider Liberty All-Star Equity (USA), which allocates about $1 billion roughly equally among five different investment-management firms with different styles. It sounds like a gimmick, but it's worked well. So far this year (through Wednesday), the fund has returned a whopping 54 percent. Over the past five years, returns have averaged 5.4 percent annually, compared with 0.1 percent for Spiders. The fund's top holdings include the Progressive Corp. (PGR), property and casualty insurance; Freddie Mac (FRE), provider of mortgage funds; and Amgen (AMGN), biotech drugs.

Liberty's expense ratio is on the high side at 1.1 percent. It holds the average stock for about two years (a turnover ratio of 52 percent), compared with just a year for the typical domestic mutual fund. Patience is a virtue in investing, and closed-ends, in part because they don't face the threat of redemptions, tend to have more stable portfolios.

Liberty's big gains this year came both from the appreciation of the stocks in its portfolio (up by about one-third) and from a shift from trading at a discount to trading at a premium. Closed-ends often get that kind extra boost, almost like leverage, when they get hot.

I make it a rule never to purchase a closed-end at a premium. Why buy a dollar for $1.02? And I try to find closed-ends that have a history of fairly stable discounts. A good example is Adams Express (ADX), which, like Tri-Continental, is an old-timer that concentrates on blue chips. Launched in 1929, Adams last week declared its 67th straight annual dividend. Its top holdings include American International Group (AIG), the insurance giant; Pfizer (PFE), drugs; and Cisco Systems (CSCO), Internet infrastructure.

Adams currently trades at a discount to NAV of 11 percent. Since 1995, its average annual discount has fluctuated only between 10 percent and 17 percent (in contrast, Gabelli has ranged from a premium of 6 percent to a discount of 25 percent). The fund carries a tiny expense ratio of 0.19 percent. Its returns have run close to those of the S&P for the past 10 years, and it's up 22 percent so far in 2003. If you decide to buy just one closed-end as a core holding, this could be the best bet.

But not all closed-end funds own blue-chip stocks. Some concentrate on special sectors. One of the best closed-ends -- a subject of a column of mine in 1996 -- is First Financial Fund (FF), which owns a portfolio of financial stocks, including Countrywide Financial (CFC), Hudson City Bancorp (HCBK) and UnionBanCal (UB). The fund has produced annual returns averaging more than 17 percent over the past 10 years. So far this year, it's up 39 percent, and it trades at a small discount.

The single largest category of closed-ends is tax-exempt municipal bonds, available by state or a national mix. A report last month by UBS Investment Research found that there are 286 muni funds, with $57 billion in assets, out of a universe of 571 closed-end funds, with $135 billion in assets. The reason is simple: Since closed-ends can't be redeemed, managers can keep a stable portfolio of muni bonds, which typically are thinly traded. Forced to come up with cash to meet redemptions, the manager of a muni mutual fund, by contrast, might have to take a knock-down price on an illiquid bond.

Similarly, closed-ends are excellent vehicles for single-country portfolios of stocks in emerging markets. There are currently 47 such funds, with total assets of $6.4 billion. They include some of the biggest winners of 2003: the Thai Fund (TTF), up 151 percent; China Fund (CHN), up 158 percent; Indonesia Fund (IF), up 120 percent; Chile Fund (CH), up 74 percent; and Turkish Investment Fund (TKF), up 83 percent.

Many of these funds are now trading at high premiums: China, at 36 percent; Indonesia, 19 percent. It's nuts to buy these funds now. Still, when a fund moves from discount to premium, the gains to investors can be enormous. Look at Japan Smaller Cap Fund (JOF). Last year, it carried a discount to NAV of 24 percent; currently, it carries a premium of 16 percent. No wonder the stock has returned 71 percent over the past year.

More attractive is the India Fund (IFN), which has returned 112 percent over the past 12 months but still trades at a discount to the value of its underlying stocks. And, in general, country funds are the best way to own shares in smaller markets.

You can buy well-managed funds, run by some of the best names in the business, including Morgan Stanley, Credit Suisse, Nomura and Templeton. One of the most intriguing choices right now is Templeton Russia (TRF), managed by Mark Mobius. Hurt lately by the Yukos controversy, the fund is still up 76 percent for the year but trades at a discount of 5 percent to NAV.

Douglas Ober, who is chairman of Adams Express and a related closed-end, Petroleum and Resources (PEO), recently said in a letter, "Closed-end funds are not implicated in the investigation [of mutual funds]. The way our shares are traded and priced precludes the type of market timing and late-trading practices that have been uncovered."

That's true. There's no such thing as a perfect investment. Closed-ends are cleaner than mutual funds, but they also present special risks to investors through their discounts.

But, in many cases, the benefits of closed-ends outweigh the drawbacks, and, in the end, investors should seriously consider adding these investments to their portfolios.

Of the funds mentioned in this article, James K. Glassman owns First Financial.

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