Be open to closed-end funds

These exchange-traded vehicles can garner high returns

Buy a top-rated Morningstar fund for 86 cents on the dollar? That’s the deal locked in by investors who bought Central Securities (AMEX: CET) at one point this past summer: The fund held stocks worth $39.26 per share yet it traded at $33.875, for a 13.7% discount. Also available were General American Investors (NYSE: GAM), another five-star fund trading at a 7.8% discount; Tri-Continental (NYSE: TY), a four-star fund priced at 18.8% below market value; and dozens of others with discounts of 20% or more.

There is a key difference between mutual funds and closed-end funds. Mutual funds are “open-end,” meaning that they continually sell shares to and buy shares from investors, receiving or paying a price that reflects the value of their holdings. Closed-end funds have a certain amount of money to invest, from funds raised in an initial public offering. (Additional capital may be raised in secondary offerings.) After their IPOs, closed-end funds trade like stocks, with their trading prices determined by supply and demand rather than by the value of their underlying securities. As a result, closed-ends usually trade at a discount or a premium to net asset value (NAV).

“Closed-end funds have certain advantages over mutual funds,” says Thomas J. Herzfeld, a Miami-based investment advisor whose firm publishes The Investor’s Guide to Closed-End Funds ($475 for 12 issues; www.herzfeld.com). “Managers don’t have to hold cash to meet possible redemptions, so they can be fully invested in stocks or bonds, which are likely to generate higher returns long term.”

Gregg Wolper, an analyst at Morningstar Inc., Chicago, says that the closed-end nature of these funds can be a plus. “Closed-ends aren’t being forced to buy at market tops, when cash flows in, or to sell into market corrections, when cash flows out.”

Indeed, the performance of closed-ends has been solid, short and long term. The Herzfeld Closed-End Average is up about 14.46% from the fourth quarter of 1999 while the Dow Jones industrial average is flat. “Since we introduced our average in late 1987, it has outperformed the Dow by around 33%,” say Herzfeld.

Wolper points to another advantage: They have no minimum.

In addition, the fact that closed-end funds often trade at a discount to NAV offers investors another way to make money: not only can the prices of the underlying securities go up, the discounts may narrow or even go to a premium. “You should track a closed-end fund for at least six months before buying,” says Herzfeld. “Try to buy when the discount is at least five percentage points wider than the average. If a fund’s average discount to NAV is 10%, buy it when the discount is at least 15%.”

TOP 5 CLOSED-END EQUITY FUNDS

Fund Name (Ticker)

NAV Year-to-Date Total Return*

NAV 1-Year Total Return*

NAV 3-Year Annualized Return*

NAV 5-Year Annualized Return*

Premium Discount

Telephone
Number

H&Q Life Sciences Investors (HQL)

61.21

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