Closed-end funds seem to be the forgotten stepchild in the mutual fund world -- a misunderstood investment option that can be quite successful. While nearly 10,000 options exist for investors in open-end funds, only about 500 are available in the closed-end fund universe. One reason investors shy from the closed-end fund option is the presence of the premium/discount.

The Premium/Discount

Open-end fund shares are purchased at NAV, or net asset value. Closed-end funds, however, trade like stocks, with their prices fluctuating in line with investor sentiment, political occurrences, currency issues and so on. So, while the NAV may be holding steady, the market value (represented by the discount/premium) may move in either a positive or negative direction. This discrepancy between market price and net asset value is one of the most spotlighted variables of closed-end funds. A closed-end fund trades at a discount when the price determined by the market is lower than its portfolio value or NAV. On the other hand, when the fund is trading at a higher price than its portfolio value, the fund is said to be at a premium.

The discount is probably the most watched fund characteristic for two very different and important reasons. First, when a fund trades at a discount, it provides a buying opportunity for potential shareholders. For example, if a fund is valued at $20 per share, but currently trades on the market for $17, it is trading at a 15 percent discount. These are the kinds of values most experienced closed-end fund investors tend to look for. The second reason the premium/discount is important actually contradicts the first: the discount erodes value. If you are a current shareholder of a fund that is trading at a price 15 percent less than what it is worth, then you are not realizing the true value of your investment.

Is the discount a sign of value or of robbery? This is the question that has generated strong debate for years. Many people, from academia to Wall Street, have tried to explain the presence of the closed-end fund discount, but no one has been able to agree on any one explanation. High management fees and other expenses are often cited as causes for the discount. Unrealized appreciation, illiquid securities in the portfolio and poor performance have also been cited as explanations.

So why would you want to invest in such a vehicle? There is a common misconception that one has to be a sophisticated investor or a day-trading arbitrageur in order to make any money in closed-end funds. While every investor who buys and sells securities should be educated, you don't need a special degree to invest in closed-end funds.

Since the presence of the discount is such a hotly-argued phenomenon, Wiesenberger decided to put it to the test. Our analysts set up a hypothetical illustration to invest $10,000 in the five most deeply discounted funds. We chose May 1987 as a random start date to counteract the presence of the January effect, when stock prices rise throughout the month due to higher demand. This demand is brought about by money managers attempting to "window dress" their portfolios. Once we purchased the funds, we held them for a year and in May 1988, we sold them and bought the next five most deeply discounted funds. We continued this cycle for ten years, with the funds listed below.

So what are the results? On May 30, 1997 we realized a total return of 357.80 percent. That's an average of 16.43 percent per year. In dollar figures, a $10,000 initial investment became $45,780 over the time period. Not bad for only trading the funds once a year.

For posterity's sake, we also wanted to look at this scenario through calendar years. We started by investing $10,000 in the five most deeply discounted funds on December 31. We bought the five funds on January 1, 1987 and sold them on December 31, 1988. As before, we repeated this process for ten years. The results in the chart below are similar to the funds bought and sold in May, but magnified. On December 31, 1997, we realized a total return of 400.55 percent, an average annual return of 17.47 percent. In dollar terms, we ended with $50,055.

Since the discount cannot exist without the premium, we decided to conduct the opposite scenario as well. We duplicated the effort with funds which were trading at a value higher than their NAV's (a premium). Again, we started with five funds that had the highest premiums in May and December 1987 and sold them each year to buy the next five funds with the highest premiums. We continued with this pattern for ten years as well. While we generated great returns buying funds at a discount, the same did not happen with the funds trading at a premium. We generated a total return over a ten-year period of -5.65 percent and -0.32 percent, respectively. In dollar figures, this percentage left us at $9,435.45 and $9,968.21, respectively.

It should be remembered that, while these returns are indeed impressive, some deeply-discounted closed-end funds suffer substantial losses. For example, the closed-end fund Engex has retained an average discount of 22.20 percent over the past ten years. Unfortunately, over the same time period, the fund's market return is only 1.21 percent. Also, while the practice of buying deeply-discounted closed-end funds rendered impressive returns -- 16.43 percent average annualized return when invested in May and 17.47 percent average annualized return when invested in December -- other investment tools have provided convincing gains as well. The S&P 500 posted a 14.72 percent 10-year gain through May 1997 (which includes the October 1987 market debacle). The index has gained over 18 percent annually through December 1997.

While perfect market timing may be a near-impossible investment strategy, the practice of obtaining the closed-end funds with the deepest discounts is a feasible process. It may not be for everyone -- the process can be a volatile one -- but those willing to take the risk could reap impressive rewards.

Wiesenberger, the country's first mutual fund tracking service, has provided mutual fund data to financial professionals for more than 55 years. It is the leading provider of customized retirement, marketing and sales, and research software to both distributors and sponsors, including financial planning companies, wirehouses, broker/dealer firms, banks, mutual fund and insurance companies. Wiesenberger is a division of Thomson Financial Services (TFS), a leading provider of information services and work solutions to the worldwide financial community. TFS employs more than 6,000 people in more than 40 locations dedicated to the success of our clients and is part of The Thomson Corporation. The principal activity of The Thomson Corporation (TTC) is information and publishing, where in 1997 the Group had some 40,000 staff members and a revenue base approaching US$6 billion. TTC's common shares are quoted on the Toronto, Montreal and London stock exchanges.

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