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The Discount Mystery

Where - and why - can you buy a buck for 90 cents?

When exchange-traded funds appeared in the 1990s, some observers predicted that the new vehicles would doom their older cousins, closed-end funds. But lately those boring old closed-end funds have been attracting renewed attention. Total assets in closed-ends reached $276 billion at the end of 2005, up from $254 billion in 2004 and $214 billion in 2003, according to the Investment Company Institute. The peculiar advantages of closed-ends help account for their survival: By using leverage and other techniques, top closed-ends have been outdoing their benchmarks. At a time when Treasury bonds still pay meager yields, dozens of closed-end funds yield 9 percent or more.

Much of the recent growth of closed-ends has come from option-income funds, a wave of which have appeared in the last year and half (there are now 35 of them). Most of the option funds buy blue-chip stocks and then sell calls on them. The calls provide a steady stream of income, helping the portfolios to yield 8.5 percent to 10.5 percent, while typically recording less volatility than an S&P 500 index fund. But after delivering healthy returns for the past year, the option funds no longer sell at bargain prices, says Alexander Reiss, an analyst with Ryan Beck. Reiss does not expect that investors will achieve substantial capital gains soon from funds like BlackRock Enhanced Dividend and Eaton Vance Enhanced Equity Income II. Still, he says, they help diversify a portfolio. “These funds don't necessarily track bonds, so they can offer a way to diversify a fixed-income portfolio,” he says.

Considering the lofty yields of the option funds, it's not surprising that they have attracted more than $8 billion in assets. Why don't conventional, open-end mutual funds try the same approach? One or two have, but writing calls on stocks is difficult for open-end funds, which have to pay out to departing shareholders. Closed-end funds, on the other hand, trades like a stock; indeed, they are launched by raising a fixed amount of money and issuing a fixed amount of shares.

When Depression Is Appealing

One of the most appealing characteristics of closed-ends is that the shares periodically become depressed and sell at discounts to the value of the portfolio assets. When that happens, an investor may be able to buy a dollar worth of securities for 90 cents or less. Consider MFS Intermediate Income Trust, which sells for a discount of 11.48 percent. With more than 90 percent of its assets in Treasuries and securities rated AAA, the MFS portfolio does not take big risks. But, because of the discount, the fund yields 5.91 percent, well above the 5.0 percent paid by intermediate Treasuries. “This is a conservative fund that delivers an unusual yield,” says Ryan Beck's Reiss.

Academics have long debated why the closed-end discounts persist. According to some theories, open-end funds promote their offerings heavily. [By advertising, the managers can gain more assets and increase their fee income.] On the other hand, closed-ends have less incentive to attract new customers, and many of the funds remain undiscovered. Closed-end funds could also sell for discounts because of poor performance or potential tax liabilities. Closed-end bond funds may become depressed after dividends have been cut or when investors fear that rising interest rates will erode bond values.

Investors can find sizable discounts on many of the bond funds that were recently sold by Citigroup to Legg Mason. In the deal, Legg acquired two-dozen funds with $8 billion in assets. Uncertainties about the deal helped to weaken share prices, says Thomas Herzfeld, who heads Thomas J. Herzfeld Associates, a money-management firm that specializes in closed-ends. “A certain percentage of the people didn't want the funds moved to Legg Mason, so the shareholders sold out,” says Herzfeld.

Now Herzfeld recommends many of the former Citigroup funds because of their hefty discounts. He favors Salomon Brothers Global Income, which has a discount of 13.24 percent and yields 8.19 percent. The fund holds a mix of foreign and U.S. bonds and has an average credit quality of BBB, the lowest investment-grade rating awarded by Standard & Poor's. The fund boosts yield by holding some below-investment-grade issues. For a purer dose of high-yield U.S. bonds, consider another former Citigroup fund, High Income Opportunity, which has a discount of 13.09 percent and a yield of 8.08 percent.

Some of the most intriguing closed-end funds are run by star managers of open-end funds, says Alfred Blomquist, a registered investment advisor in Franklin Lakes, N.J. Blomquist buys the closed-end when the discounts appear fat. Blomquist currently favors Dreman/Claymore Dividend & Income, an equity fund that sells at a 15.53 percent discount and boasts a yield of 6.73 percent. The closed-end is managed by David Dreman, the star manager who has outreturned 95 percent of his large value competitors during the past decade with the open-end DWS Dreman High Return Equity A. The two Dreman funds have nearly the same list of value holdings, including tobacco company Altria Group and troubled mortgage financer Fannie Mae. Blomquist argues that when you buy a manager's closed-end fund at a big discount, you have a good chance of outperforming the open-end version of the portfolio. “The best way to buy David Dreman is with the closed-end fund,” says Blomquist.

Blomquist also likes Calamos Strategic Total Return, a closed-end run by the star team of Nick and John Calamos. The pair has outdone 99 percent of their competitors during the past decade with the open-end convertible fund of Calamos Growth & Income. The closed-end Calamos fund has a discount of 10.10 percent and a current yield of 8.32 percent.

Discounts help to make closed-end stock funds particularly attractive for conservative clients seeking dividend income. Consider First Trust Value Dividend, which sells at a discount of 13.75 percent and yields 2.94 percent. The fund begins screening for stocks by looking at Value Line rankings. While many investors are familiar with Value Line's timeliness rankings, First Trust focuses on picking only stocks that get high ratings for safety by Value Line. Then the fund narrows the field by picking stocks with the highest yields. The result is a fund that holds such steady names as 3M and Clorox. The fund pays a dividend every month, an important consideration for many income investors.

Another high-dividend choice is Eaton Vance Tax Advantaged Global Dividend, which boosts its yield by investing in some overseas stocks. The fund has a discount of 7.91 percent and a yield of 6.07 percent. The fund sometimes increases its income by using dividend capture strategies, buying stocks just before they pay their dividends.

Besides benefiting from discounts, closed-end funds boost yields by using leverage, something that open-ends are barred from doing. In a typical strategy, a closed-end fund might borrow by selling short-term preferred shares with a value equal to one-third of the portfolio's assets. The cash raised with the preferred can then be used to buy more stocks or bonds. For every dollar put into a leveraged fund, the investor gets $1.33 worth of assets. When stocks are rising, a leveraged fund can produce big returns. But in a poor market, the opposite can happen; the leverage will magnify losses.

In recent years, leveraged bond funds enjoyed a field day. Funds could borrow at short-term rates of around 2 percent and use the money to buy longer-term bonds with rates of more than 5 percent. Since the Federal Reserve began raising short-term rates, the leveraging has proved less lucrative. With the gap between long and short rates evaporating, some funds were forced to cut their dividends. Investors who worry that interest rates will continue rising may want to stay away from leveraged bond funds altogether. But there are ways to use leveraged funds, even in a time of rising rates. One approach is to buy leveraged funds at a discount now and hold them for five or 10 years. “Over an entire interest-rate cycle, a leveraged fund is likely to outperform a similar portfolio that is not leveraged,” says Anne Kritzmire, managing director of Nuveen Investments.

Another approach is to buy a leveraged fund that has a buffer against rising rates. Nuveen Tax-Advantaged Total Return Strategy uses about 30 percent leverage to boost its portfolio of dividend-paying stocks and fixed income. But part of the assets is invested in floating-rate loans. As short-term interest rates rise, so do yields on the loan investments. That generates income that helps to offset any harm done by rising rates.

Equity investors who prefer little or no leverage can find some top-performers in the closed-end ranks. One of the granddaddies of the industry is General American Investors, which was founded in 1927. During the past decade, the fund has returned 15.4 percent annually, about 6 percentage points ahead of the S&P 500. General American has achieved its stellar record with an old-fashioned approach, buying growth stocks at a reasonable price and holding them for years. The fund's annual turnover often runs about 20 percent. Fund president Spencer Davidson says that General American's structure helps the fund execute its patient approach. “As a closed-end fund, we don't feel the pressure to deliver big returns every quarter,” he says.

Closed-End Funds That Deliver Fat Yields
Fund Ticker Category Discount Yield
BlackRock Enhanced Dividend BDJ Equity Income 5.87% 8.96%
Calamos Strategic Total Return CSQ Growth and Income 10.10 8.32
Dreman/Claymore Dividend DCS Equity Income 15.53 6.73
Eaton Vance Enhanced Equity Income II EOS Equity Income 5.65 9.16
Eaton Vance Tax Advantaged Global ETO Global Equity 7.91 6.07
First Trust Value Dividend FVD Equity Income 13.75 2.94
General American Investors GAM Growth 10.46 2.88
High Income Opportunity HIO High Yield 13.09 8.08
MFS Intermediate Income MIN Global Income 11.48 5.91
Nuveen Tax Advantaged Total Return JTA Equity Income 9.40 6.74
Salomon Brothers Global Income EHI Global Income 13.24 8.19
Source: Data from 5/9/06.
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