Thousands of investors these days are getting pitched by their brokers to buy shares of a hot-selling investment called closed-end funds. Unfortunately, many investors are buying without fully knowing what they're doing--and suffering poor initial returns as a result.
Sales of closed-end funds, a form of mutual fund whose shares trade publicly on stock exchanges, have been booming since the October crash. So far this year, 36 new closed-end funds have started with total assets of $13.2 billion, compared to 35 new funds worth $11 billion in all of last year, according to Thomas J. Herzfeld, a Miami investment adviser and leading expert on the funds.
Four came to market just this past Thursday and Friday alone, he notes. The largest initial public offering of any U.S. stock was not from Conrail or General Motors but instead was from a closed-end fund, MFS Intermediate Income Trust, that raised $2 billion last March.
No wonder they're popular: Most of the new funds invest in bonds offering yields in the 10% to 12% range--the perfect lure for investors still jittery about the stock market. Other funds invest in stocks, and some have beaten the market so far this year.
But while you should consider these funds as part of your portfolio, you will need to exercise a fair amount of care in choosing them--at least more than with conventional mutual funds.
Closed-end funds operate similarly to mutual funds in that they pool investors' money and invest in an actively managed, diversified portfolio of securities, ranging from risky investments such as foreign stocks to conservative investments such as municipal bonds. Some, with names such as the Korea Fund, Taiwan Fund, Mexico Fund and Brazil Fund, invest in stocks of a single country.
However, closed-end funds differ from mutual funds in one major way: Closed-end funds issue only a fixed number of shares, traded on public stock exchanges like the New York Stock Exchange. Mutual funds, on the other hand, create new shares on demand, which you buy from the fund and sell back, too. The shares of a mutual fund are always priced at the fund's net asset value per share.
But with a closed-end fund, share prices fluctuate higher or lower than the net asset value per share, depending on investor demand for those shares. If demand is low, shares could trade at a discount below net asset value. For example, Excelsior Income Shares, a closed-end bond fund traded on the NYSE, recently had a net asset value of $16.89 a share, but its shares were trading for only $15, giving it a discount of 11.2%.
On the other hand, some funds subject to high demand trade at premiums above their net asset value. Some premiums run as high as 100% or more, meaning investors are willing to pay $2 for every $1 of assets.
Such fluctuation is one of the key reasons why closed-end funds are attractive. In effect, you can profit three ways. First, if you can buy fund shares at a discount, you get assets more cheaply than if you bought them individually. For bond funds, that in effect raises the dividend yield. Second, if fund managers invest wisely, the net asset value of the portfolio can rise, pushing up the share prices.
And third, if demand for fund shares increase, the discount might narrow or the premium might rise, allowing you to make yet another capital gain.
Herzfeld argues that closed-end funds, if bought at deep discounts of 20% to 25% below net asset value, will outperform conventional mutual funds with similar investment objectives over time. For the first six months of 1988, when the Dow Jones industrial average rose 9.96%, Herzfeld's closed-end average of 20 large U.S. equity funds gained 15.89% (equity mutual funds also beat the Dow in that period, but with a somewhat smaller 13.68% gain).
Of course, you can also lose money these three ways, too--as investors in many closed-end stock funds found out last October. Not only did net asset values plummet with the crash; discounts actually widened--giving investors a double negative whammy.
Accordingly, buying closed-end funds is more complicated--and potentially more rewarding--than buying conventional mutual funds. Not only must you look for good funds with good management, you also should look for funds whose discounts are likely to fall or whose premiums are likely to rise.
But as if defying logic, thousands of investors do just the opposite. They buy closed-end funds at their initial offerings, when share prices in effect sell at an artificial premium above net asset value. That is because underwriters of the funds--the brokers trying to sell shares to you--take a huge chunk out of fund assets to pay themselves fees and sales commissions. Those fees typically run as high as 6% to 7%. Thus, with a new closed-end fund, you may be paying $1 to get only 93 cents worth of assets.