Closed-End Funds Sell for Bargain Prices

• ByStan Luxenberg, Special to TheStreet.com
• On 8:58 am EDT, Friday October 30, 2009

NEW YORK (TheStreet) - Mutual fund investors often make the mistake of ignoring closed-end funds because they're small. However, some closed-end funds now sell at intriguing discounts to the value of their assets.

"It makes sense to buy a closed-end fund at a discount instead of taking a comparable open-end mutual fund," says Mariana Bush, a closed-end analyst for Wells Fargo.

Some managers of conventional mutual funds also run closed-end funds. Among the top performers who oversee both kinds of funds are Ron Baron, Mario Gabelli and Bill Gross.

To appreciate the appeal of closed-ends, consider the record of Jeffrey Gundlach, who manages one of the top-performing bond mutual funds, the TCW Total Return Bond Fund. During the past five years, the fund has returned 7.1% annually, outdoing 99% of its intermediate-term competitors, according to Morningstar.

Gundlach also runs the TCW Strategic Income Fund, a closed-end that has returned 8% annually during the past five years and sells for a discount of 2.5% to its net assets.

"The closed-end fund gives you a unique opportunity to invest in a top manager who has been able to steer away from problems in the mortgage markets," says Patrick Galley, portfolio manager of RiverNorth Core Opportunity Fund, an open-end fund that invests in closed-end funds.

Like conventional mutual funds, closed-end funds invest in portfolios of stocks and bonds. Trading on stock exchanges, shares of closed-end funds can sometimes swing wildly, moving from discounts to premiums. This is very different from conventional mutual funds, which tend to be more stable because they always trade at the value of their net assets.

The difference between open-end and closed-end funds became very apparent during the market turbulence of the past year. In 2008, open-end long-term municipal funds lost 9%. This year, the funds sprang back, returning 19%. For closed-end funds, the road has been much rougher. Many funds lost 25% in 2008 before springing back more than 40%.

The Federated Premier Municipal Income Fund, a closed-end, lost 27% in 2008 and returned 69% this year. The fund achieved such a huge gain partly because the shares are trading at a 6% premium compared with a 17% discount in 2008.

The Federated Investors fund also magnified the gains by using leverage. While conventional mutual funds typically use little or no leverage, many closed-end funds borrow 30% or more of the value of their portfolios.

In the course of a year, closed-end funds often swing from discounts to premiums. Advisers caution that investors should focus on buying at discounts. Investors who pay premiums are likely to underperform conventional mutual funds.

In recent months, investors have been pouring into closed-end bond funds and pushing premiums up to levels that many analysts considerable unsustainable. One of the most noteworthy performers has been the PIMCO High Income Fund. The appeal of the fund is clear. Managed by Bill Gross, the fund yields 17%. But analysts cautious that the PIMCO fund seems poised to disappoint. With investors chasing high-yield bonds in recent months, the fund has more than doubled and now sells for an astronomical premium of 40%.

When the inevitable fall occurs, the decline could be steep. In the past, the shares have sold for discounts periodically. Last year, the discount reached more than 20%.

Instead of chasing hot bond funds that command premiums, closed-end investors may get better results by buying stock funds that sell at discounts. A solid choice is the SunAmerica Focused Alpha Growth Fund, which is run by Ron Baron, who manages open-end Baron Growth Fund, and Tom Marsico, the veteran manager of the Marsico Focus Fund. The SunAmerica fund currently sells for a discount of 13%.

Part of the reason for the wide discount is that the fund cut its dividend during the market tumult of last spring. Angry investors dumped the shares. But the fund remains a sound choice, holding growth stocks, such as Apple and for-profit educator DeVry.

Another intriguing fund is the Gamco Investors' Gabelli Dividend and Income Fund, which sells for a 15% discount. The closed-end fund is run by Mario Gabelli who is better known for his Gabelli Equity Income Fund, an open-end fund that has returned 4.4% annually during the past five years, outdoing 93% of its large value competitors. The two Gabelli funds have many holdings in common, including Chevron, Intel, and AT&T. By investing in the closed-end, you can own blue chips at a bargain price.

-- Reported by Stan Luxenberg in New York.

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