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The Weird World Of Closed End Funds


Mutual Fund Scoreboard

THE WEIRD WORLD OF CLOSED-END FUNDS

The Scoreboard will help you analyze their strange behavior

Markets sometimes suffer from a tinge of irrationality, but closed-end funds seem downright schizophrenic. These funds invest like mutual funds but trade on the market like stocks, and that leads to some strange behavior. Many trade at a discount to the value of their underlying securities, and some at premiums far above what they're really worth. What's an investor to do?

Turn to the BUSINESS WEEK Mutual Fund Scoreboard for closed-end funds. Starting on page 108, we review 120 equity funds, rating them by risk-adjusted returns; measuring by their portfolio and share-price performance; and tell you how much of a discount or premium the fund trades at. You'll also find 70 closed-end bond funds in these pages, and an additional 280 in BUSINESS WEEK Online (www.businessweek.com).

The Scoreboard shows just how bizarre these funds can be. Look at the Salomon Brothers Fund, a portfolio of U.S. blue chips that delivered a 30% average annual return over the past three years and earned an A in the BUSINESS WEEK Mutual Fund Scoreboard (table). It trades at nearly a 10% discount to the value of its blue-chip portfolio, or 90 cents on the dollar.

Then there's the Thai Fund. Its portfolio lost 77% of its value last year, destroyed by Thailand's economic crisis, a plunging equity market, and a rapidly depreciating currency. It gets an F for risk-adjusted performance. Still, the Thai Fund trades at a huge 145.5% premium. Put it this way: Every $1 invested in the fund buys 41 cents of assets. Most of the funds that invest in the battered Asian bourses trade at big markups as well.

How can the premium for a fund balloon in a bear market? "The [net asset value] collapses, but the share price doesn't collapse as much," says fund specialist Thomas J. Herzfeld of the Miami firm that bears his name. Still, the Asian meltdown started months ago, and the fund shares have had more than enough time to catch up. But in many cases, the premiums have actually increased. One reason is that traders often buy the shares, betting on a small but quick profit. "If you go from $3 to $4, you've made a third on your money," says Herzfeld, who "flips" shares himself. But he cautions investors about buying high-premium funds because of the "unfavorable risk-reward ratio.""YIELD IS SCARCE." One way to play the Asian mess is to invest in well-run Latin American funds, which have better fundamentals and sell at discounts, says William Dinning, Merrill Lynch & Co.'s country fund analyst. Among his suggestions are the Mexico, Emerging Mexico, and Brazil funds. Adds Dinning: "If Asia recovers, all the emerging-market funds will benefit as well."

Among the closed-end bond funds, the funds with the highest payouts generally command premiums as well. With interest rates falling, "yield is scarce, and investors will pay up for it," says Gregg Wolper, closed-end fund editor for Morningstar Mutual Funds. And since the spread between short-term and long-term rates is paper-thin, some funds that have in the past boosted yields by borrowing short-term money and buying long bonds, now are unable to do so.

Buying bond funds strictly on their yield can be a dangerous move. You have to look further: The fund could be taking on unreasonable credit or currency risk, or it may own bonds that could be called away and would have to be replaced with lower-yielding securities. Still, Wolper says if the fund passes muster, it's okay to buy at a modest premium. That's why A-rated Van Kampen American Capital Intermediate-Term High Income can sell at a 12.9% premium. Based on its payouts, the current yield is a plump 9.4%--four percentage points more than comparable Treasuries.

True, the odd behavior of closed-ends makes them difficult to analyze--and many investors just don't bother. That makes the opportunities all the richer for those who do.By Jeffrey M. Laderman in New YorkReturn to top


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