Closed-End Funds Ignored By Investors But Discounts To Asset Value Indicative Of Market Near Its Low, Not A Peak

With all the rush to pour money into stock mutual funds lately, activity in closed-end stock funds has stayed remarkably quiet.

Like open-ended stock funds, which have surpassed $1 trillion in assets during this raging bull-market year, closed-end funds are pools of money formed to invest in portfolios of securities.

The only major difference between them lies in the way fund shares are bought and sold.

But instead of commanding premium prices, many closed-end stock funds have recently sold at the widest discounts from the asset values of their holdings since the late 1980s.

“Closed-end portfolios are being ignored by the average investor,” say analysts at Standard & Poor’s Corp. in the firm’s advisory publication The Outlook.

“Closed-end fund investors seem to be becoming more pessimistic even as investors in general are becoming more optimistic,” adds Norman Fosback, editor of a group of investment letters published by the Institute for Econometric Research in Florida.

This disparity seems at least partly to arise from questions of style and taste. Millions of investors have grown comfortable with open-ended funds, which issue new shares and redeem old ones each business day to accommodate the flow of buy and sell orders. The price is always determined directly by a fund’s net asset value per share.

Closed-end funds, by contrast, start out by selling a fixed number of shares that are subsequently traded in the secondary market, just like stocks of industrial and commercial companies. So closed-end prices are determined by that market, and can fluctuate above and below the net asset value.

An index of closed-end funds calculated by Fosback showed a discount of near zero in early 1993. Since then, it has widened to the neighborhood of 12 percent, not far from the 15 percent level it reached after the market crash in 1987.

This complicating factor apparently puts off many investors. Analysts say it also can present an opportunity, if you can follow a strategy of buying closed-ends when discounts are large and selling when they shrink to near zero or turn into premiums.

Declares Fosback: “Our research demonstrates that since 1980, closed-end funds beat open-end funds as a class, and that the application of simple buy and sell rules enhances that superiority.”

The risks?

“There are times closed-end funds should never be bought, and even in the best of markets some closed-end funds can be expected to significantly underperform the market. Closed-end funds selling at premiums above their net asset value may be especially risky investments.”

And timing funds, like timing stocks, is a very difficult task.

Whatever the reasons for current discounts in closed-end funds, they provide some comfort to anyone who is worried that stock investors might be getting dangerously exuberant and overconfident.

Why?

Because the current attitude toward closed-end funds more closely resembles the pattern that has prevailed near market lows, not peaks.

“The wide discounts prevalent on closed-end stock funds would seem to be a harbinger of further market rallies,” Fosback said.