Closed-End Funds, Open-Ended Returns

Closed-end funds now look like the "comeback kids" of mutual funds.

"Many funds are now trading at an unusually deep discount," says Donald Cassidy, an analyst at Lipper Analytical Services in New York.

For careful investors "shopping for value," selected closed-end funds can be a good buy right now, he says.

Closed-end funds invest in stocks and bonds - just as open-end mutual funds do - but the number of shares is fixed, and they trade like common stocks. So their share price depends both on the securities the fund owns and investor demand. Open-end funds generally issue an unlimited number of shares, and their price depends on the prices of underlying securities.

How discounts work

One of the keys to closed-end funds is a price gap, the discount noted by Mr. Cassidy.

If, for example, a closed-end fund owns 10 shares each of General Electric (at $60 a share) and IBM (at $84 a share), its underlying securities are worth $1,440.

And if that fund has issued 100 shares, its net asset value is $14.40 a share. If this were an open-end fund, you could buy into it for about $14.40, because the fund itself would just sell you some new shares, as many as you want. When you want to sell, you sell the shares back to the fund at, roughly, its current net asset value.

But since closed-end funds have limited shares, the share price reflects market demand as well as net asset value. There's a gap.

Right now, that gap puts the average closed-end share price about 10 percent below the net asset value, Cassidy says, down from about 14 percent a year ago but still wider than usual.

The bottom line is that investors often not only buy but sell at a discount, and the gap can change.

Investors have generally closed the door on closed-end funds. The discounts make them hard to evaluate, and many financial planners discourage investing in them.

Discounts will probably shrink more in the months ahead, some experts predict, as closed-end funds come under pressure from the US Securities and Exchange Commission to close the gap. The SEC apparently sympathizes with investors who have bought funds and watched discounts widen.

Some funds are buying back shares to close the gap. Others plan to go open-ended.

And the funds have their supporters.

"For most small investors, there is really no more reason to be concerned about buying closed-end funds than open-end funds," says Gregg Wolper, who tracks closed-end funds for Morningstar in Chicago.

Lipper counts 505 closed-end funds: 350 investing in bonds; 155 in equities. Of the latter group, about 95 invest outside the US, often in just one country.

The foreign funds have been some of the hottest of late.

Premium on Russia

The Templeton Russia Fund, leading the way this year with a 58 percent return, now sells at a premium of 0.5 percent. But investors were even more bullish on its prospects in early April, when the premium was 5.2 percent.

One closed-end advantage, Mr. Wolper says, is structure. The share cap lends itself to careful management. Since new shares are not being created on a daily basis, managers don't have to worry about putting new money to work - rushing out to buy securities they may not want.

Nor do they have to worry about daily redemptions - sometimes having to sell securities prematurely to raise cash for investors who have pulled out.

Moreover, the managers can buy more unlisted securities than are allowed for an open-end fund, Wolper says. That enables a fund manager to push the envelope for higher share-price appreciation.

The funds trace their origins back to the "investment trusts" of the 1920s, Cassidy says. These trusts were highly leveraged, which means they bought stock with borrowed money, and that contributed to the severity of the 1929 stock market crash.

Of some 500 trusts active in the '20s, about a dozen have survived.

The biggest and perhaps best known of the diversified equity funds is the J. & W. Seligman Tri-Continental Corp.

Charles Kadlec, the fund's managing director, says the fund's $2.9 billion in assets cover 150 companies - well-known names like General Electric, Microsoft, and PepsiCo.

For the year ending May 23, the fund is up 21 percent.

Funds to consider

Morningstar's Wolper finds these funds attractive:

* Central Securities, investing in health-care, up 11 percent for the year to date through May 30 (212-688-3011).

* H & Q Health Care Investors, investing in venture capital firms, down 12 percent year to date but it may be attractive now (800-327-6679).

* Global Health Sciences, up 10 percent year to date (800-528-8765).

* Tri-Continental (800-221-7844).

* F & C Middle East, up 27 percent year to date (212-713-2848).

* Europe Fund, a solid though slightly conservative fund, up 6.2 percent year to date (800-543-6217).

* Templeton Russia Fund, up 58 percent year to date (800-292-9293).

TIPS FOR BUYING CLOSED-END MUTUAL FUNDS

Analysts of closed-end mutual funds offer these shopping hints:

* Avoid funds trading at a high premium to the value of their assets, unless the fund is producing scorching hot gains. The premium could suddenly shrink or disappear, leaving you with a loss.

* Avoid brand new funds. Discounts usually appear in the first few weeks after a new fund hits the market, since a little more than 5 percent of the proceeds go to brokers and underwriters.

* With discounted funds, look for one in the middle of the discount range for the past year. Avoid the deepest end of the range, since a particularly deep discount may suggest that the fund is stuck in the doldrums.

* Information about discounts can be obtained from Lipper and Morningstar. The New York Times, The Wall Street Journal, and Barron's carry weekly closed-end tables.

*Make sure you feel comfortable with a fund's diversity or lack of it. Seligman's Tri-Continental invests across a broad range, while single-country funds, such as Templeton's red-hot Russia fund, put all their eggs in one basket. Call the fund for its annual report plus a list of its stock holdings.