Magazine

'Tis the Season for Closed-End Funds


One of the few near-certainties of the stock market is that every December, many closed-end funds get cheap. That's because investors dump losers to take tax losses before yearend. "I can't recall a year where December hasn't been the best time to buy closed-end funds," says Thomas Herzfeld, whose Miami investment firm specializes in them.

Many closed-ends--vehicles that invest like mutual funds but are bought and sold like stocks--get so cheap, in fact, that buyers get "a very good risk-reward relationship," says Herzfeld. The funds typically rebound in January as investors come back to the market to reallocate assets and establish new positions. Their recovery can provide a windfall--say, 20% in only a month, adds Herzfeld.

WIDEST DISCOUNT. Closed-end funds have a unique structure. They issue a fixed number of shares. So if demand for a fund heads south, its share price will, too--even if the portfolio's value holds steady. That's precisely what happens when tax-conscious shareholders sell: The share price swoons, but the net asset value (NAV) remains unchanged, since the selling isn't related to the fund's holdings, says Jon Maier, closed-end fund analyst at UBS Warburg. In contrast, mutual funds create new shares when money comes in and redeem them when investors cash out. And they do both transactions at NAV--or what their assets are actually worth.

For a variety of reasons, closed-end funds tend to trade at a price that's a discount to the value of their holdings. At yearend, that discount usually reaches its widest point.

This year, the pattern of widening discounts may be less pronounced, however. Because of the bear market, investors may not have a lot of taxable gains to offset and may be less motivated to chalk up losses by selling closed-end losers. Moreover, many of the municipal and investment-grade bond funds that comprise about half of the closed-end universe are posting gains for 2001.

Still, some tax-loss selling is sure to take place. After all, even without gains, investors can deduct up to $3,000 of losses from their ordinary income. Losses in excess of that are carried forward to offset future years' gains. Funds likely to be hit by tax-related selling are those investing in U.S. stocks, foreign stocks, and high-yield bonds. All three sectors have been hammered this year.

Herzfeld says good prospects can be found among the year's worst performers (table). But don't buy until after you see a fund's discount widen. The data are widely published at the end of each week, but you can always contact the fund for the latest numbers. And many, though not all, closed-end NAVs are available daily at www.nasdaq.com. (Enter the ticker symbol bracketed by X's. For example, Alliance All-Market Advantage's AMO becomes XAMOX.) To make sure investors didn't flee because of portfolio problems, check that NAV held steady even as the share price fell.

One good example is the meVC Draper Fisher Jurvetson Fund (MVC), which invests in privately-held technology companies. Tax-loss selling pushed its discount to 47% last December--allowing investors to buy $1 of assets for 53 cents. In January, the share price rebounded, and the discount narrowed to 29%. Those who rode the discount earned a cool 35% in just over a month--and Herzfeld thinks the fund has a good chance of repeating that performance this year.

Although some high-yield bond funds are candidates for tax-loss selling, be wary. Many trade at premiums to their NAVs--not because of strong demand but because the underlying bonds have fallen further in price than the shares of the fund. With default rates still high, the funds' NAVs and dividends may be at further risk, says Dennis Emanuel, a closed-end analyst at Salomon Smith Barney. Why take chances with high-yields when you can make easier money in beaten-up closed-end equity funds? By Anne Tergesen


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