BUSINESS WEEK ONLINE
Transcript of Nov. 24, 1996, conference

SECRETS OF CLOSED-END FUNDS

Closed-end funds are a little-known offshoot of mutual fund with some surprising potential for investors, including in some cases bargain prices -- and they were the topic of a story in the Dec. 2 issue of Business Week. They were also the topic of BW's Nov. 24 conference, with closed-fund expert Thomas J. Herzfeld as guest. He is founder, chairman, and president of Thomas J. Herzfeld Advisors in Miami. Tom Herzfeld was online with Jeffrey M. Laderman,  BW senior writer and author of the Dec. 2 BW story -- and of BW's Guide to Mutual Funds.

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OnlineHost: Welcome to Business Week Online! Tonight you can find out all about closed-end funds -- a special breed that can often be a bargain for the investor these days. Our guest experts are Thomas J. Herzfeld, head of Thomas J. Herzfeld Advisors in Miami (TmHerzfeld), and Jeffrey M. Laderman (JeffBW), BW senior writer, mutual-fund maven, and author of a story on closed-end funds in the latest issue of Business Week.

JackBW: Good evening to all of you on AOL. Welcome, Tom Herzfeld, and thanks for joining us. Hi, Jeff Laderman. I'm Jack Dierdorff of BW Online, your moderator tonight.

JeffBW: Hi, Jack, Tom.

TmHerzfeld: Hi, Jack. Hi, Jeff, nice to be here tonight.

JackBW: Jeff, I was going to start by asking you to define closed-end funds, but PANEEN in the audience has done part of my work.
Question: What is the difference between closed-end and an open-end?

JeffBW: An open-end fund is the mutual fund with which we're all familar. Investors buy shares from the fund company and sell them back to the fund company when they redeem. With a closed-end fund, the investor buys the shares like stock on an exchange or in the over-the-counter market. The fund company does not regularly create shares. One big difference: When you buy shares in a mutual fund, you buy at net asset value (unless there's a load on top as well). When you buy a closed-end fund, you pay the market price, which is the price at which someone will sell it to you. It may be different from the NAV.

JackBW: LaToucha sent us this question ahead of time for Tom Herzfeld. Thanks, LaToucha.
Question: The discounts of closed-end funds remain high despite the bull market. Why? Has the disparity hindered performance in your portfolios, or does it add opportunity?

TmHerzfeld: The reasons discounts remain wide probably are related to the proliferation of rights offerings that are occurring -- and also because many funds have failed to take actions to narrow the discounts to net asset value.  Many funds brought to market in the past decade contain provisions in their prospectuses requiring fund management to either buy back stock in the open market or make tender offers or possibly open-end the funds to eliminate the discounts. Unfortunately, many boards of closed-end funds have sidestepped such provisions -- the consequences being wide discounts in the industry.

JackBW: Here's another basic question about this breed of fund.
Question: What are the advantages of closed-end over conventional funds? Disadvantages?

JackBW: You may both have something to say on this. Tom first?

TmHerzfeld: One of the key advantages is that the portfolio manager doesn't have to raise capital to redeem shares, nor does he have to accommodate large inflows of cash when there are buyers of the funds. Therefore, the closed-end manager can invest in less liquid securities and also in stock markets that are thinly traded. This is one reason why the most popular form of investment company for emerging markets is the closed-end fund. A second advantage is that closed-end funds can have leveraged balance sheets. For instance, where a mutual fund only has one class of stock, a closed-end fund can be capitalized with stock and/or debt or preferred stock. Therefore, in rising markets, closed-end funds that are leveraged get more bang for the buck.

For disadvantages, what has plagued the industry for 100 years has been the discounts that develop in the marketplace when shares are trading at less than net asset value. Some, of course, can trade at premiums.

JackBW: AmoryM has this question next.
Question: If stock prices retreat, are closed-end funds likely to be hurt worse than the market in general?

TmHerzfeld: Quite often, that depends on whether the fund is trading at a premium or a discount to net asset value. For example, a fund that has been trading above net asset value is prone to a sharper price decline if that premium later reverts to a discount. On the other hand, a fund that trades at a discount, especially one wider than average, will tend to be more resistant to price declines in a falling market.

JackBW: There should be a quick answer for this question from PSULion94.
Question: Do I need a broker to purchase a closed-end fund?

JeffBW: Yes. It's the same as purchasing shares of stock.

JackBW: Next, from LSchae2368 in Beverly Hills, Calif.
Question: Are dividends in closed-end funds relative to share price or to NAV?

TmHerzfeld: That depends on the dividend policy that the board establishes. There are different components of a dividend, including net income per share, long- and short-term capital gains, and sometimes a return of capital. The analysis of a closed-end fund's yield is very complicated.

JackBW: This question also arrived in advance, from Breaker315.
Question: I have found your telephone system, "Herzfeld Closed-End Funds on Call" (305 274-5333), very helpful. I would like to see if you can provide daily net asset values. Is this possible?

TmHerzfeld: We're working on it!

JeffBW: That would be great, Tom.

JackBW: Next, from DouglasPH.
Question: With the advantages mentioned and no need for marketing expenses, it seems that closed-end funds should outperform open-end funds over the long term. Has that been the case?

TmHerzfeld: I haven't made any studies of U.S. closed-end funds vs. open-end funds, simply because our research only follows the closed-end universe. However, I suspect that closed-end funds have outperformed open-ends over the long run. And in a study I read on this question in the U.K. market, where closed-ends originated, the research did conclude superior performance for closed-ends.

JackBW: PPanos in the audience asks this one.
Question: I am a 34-year-old, and I am starting to really think about my retirement. Are closed-end funds the way to go for me?

JackBW: Glad you're planning ahead! Jeff will answer.

JeffBW: You should consider them alongside all other investment alternatives.  There are many more choices among the mutual funds. But most people miss a good opportunity in closed-ends because they don't even know they exist. If you're interested in a particular kind of mutual fund, do a little research to see if there is a similar closed-end fund that's selling at a discount.

TmHerzfeld: I would caution a new investor in closed-end funds not to treat them as mutual funds. They require a very careful two-pronged analysis. Just as the mutual-fund investor does, the closed-end investor must decide which way the net asset value is likely to move. But second, and perhaps more important, you must also assess whether the premium or discount is likely to expand or contract. A new investor to closed-end funds may be very disappointed if he correctly determines that the NAV will increase, but the fund's share price will decline. The investor must be prepared to monitor the investment on a continuous basis.

JackBW: LaToucha is in the audience tonight -- and pops this question for Tom Herzfeld.
Question: Tom, how do you evaluate closed-end buys or bargains?

TmHerzfeld: The answer to that is covered in four books I've written! However, there are approximately 20 variables to consider, including expense ratio, income ratio, liquidity, yield, windup provisions, takeover possiblilities, etc. But discount analysis is the most important single variable I consider. For beginners, I recommend buying a fund when its discount to NAV is five percentage points greater than its average discount, as long as that discount is wider than the average discount of similar funds.

JackBW: Speaking of books, Jeff, does your BW Guide to Mutual Funds discuss closed-ends?

JeffBW: Yes, it does. But it doesn't come close to what Tom Herzfeld's books do on the subject.

JackBW: Now, a question from RayLau.
Question: What do you feel are the most important things to look for in a closed-end fund? And which two or three funds currently possess the desirable characteristics you are looking for?

JackBW: That's obviously for Tom.

TmHerzfeld: I am particularly interested now in concentrating my investments in funds whose discounts will narrow or be eliminated because of ironclad provisions in their charter, bylaws, or prospectus.

JackBW: DouglasPH is back with another question.

Question: I have been pleased with returns on capital shares of dual- purpose closed-end funds. As the present ones reach the end of their lives, why aren't new ones being started?

TmHerzfeld: The most likely reason new dual-purpose funds have not come to market is that underwriters have failed to learn how to price these issues. As you know from the performance of your own investment, capital shares changed hands at wide discounts for sustained periods. This is because the preferred shareholders were getting too good a deal relative to the investors who bought the capital shares. This is obvious because the income shares always trade at a premium, while the capital shares always fall to discount. The solution, and I'm surprised no one has figured this out, is to price the income shares at original premium and offer the capital shares at a discount during the IPO.

JackBW: Jeff has a question now.

JeffBW: Tom, this is a moot point right now. But if an investor is offered a closed-end fund on the IPO, should he buy?

TmHerzfeld: It's usually the very worst time to buy a closed-end fund because the underwriting spread creates a premium to NAV. In most cases, an investor can buy a similar fund in the open market that's already trading at a discount to its NAV. So why pay a premium for a new issue?

JackBW: Jeff is following up.

JeffBW: Tom, from time to time, some funds do trade up to a premium. Is it a no-no to buy a closed-end at a premium?

TmHerzfeld: I don't rule it out, but it's like stepping up to the plate with two strikes against you. You may get a hit, but the odds are against it.

JackBW: Let's back up a few questions to clarify something for Prof1Roy.
Question: What is "Herzfeld Closed-End Funds on Call"?

TmHerzfeld: First of all, it's free -- and it enables an investor to call our office computers on the phone, punch in the symbol of a fund he's interested in, and then the computer will provide the NAV, price, and discount or premium. The computer also allows the investor to push another button to hear a message from the fund's portfolio manager to hear what that fund is invested in. We provide this as a public service.

JackBW: AOL member EZYLENDER in Florida has the next question.
Question: I like the Pilgrim America Bank & Thrift closed-end fund. Is it too late for bank funds, or do you think the stability in interest rates will continue to help this sector?

TmHerzfeld: Give me one second there. I prefer not to make an interest-rate forecast, and that is the key here. There are four funds that specialize in regional banks and thrifts that continue to trade at wide discounts despite excellent performance. Pilgrim, for instance, which trades at a discount as narrow as 9% last January and as wide as 23% in July, currently is changing hands at 17% below NAV.

JackBW: The discounts are what make the bargain, and Valhal is pursuing the reasons.
Question: Have there been any studies on the reasons for the deep discounts on these funds? What was found?

TmHerzfeld: There have been many studies in addition to my own research. Here are the most common reasons given: poor performance, illiquidity of a portfolio, expense ratio, unrealized capital gains, and tax liabilities. Of course, since closed-end funds are based on supply and demand, if there are many similar funds, they would tend to trade at wider discounts than funds that are unique. Lack of sponsorship would be one more reason.

JackBW: Robert2585 from Knoxville has a specific discount in mind in this question.
Question: Now the New Germany Fund is selling at a 23% discount to NAV. The German stock market has been doing well. When do you think the discount will disappear?

TmHerzfeld: Country funds tend to be traded at very wide discounts when they're out of favor, and at hefty premiums when everyone wants them. The factor that's affecting the four German funds relates to the previous question. When there was only one German fund --the Germany Fund, formed in 1986 -- it traded at a very large premium. But as the copycats came along -- the Emerging Germany Fund in 1990, the New Germany Fund also in 1990, and the Future Germany Fund, also in 1990 -- the competition for investment dollars in the four funds wound up depressing the prices. Also, Germany is easy to invest in relative to other markets, so investors have found other alternatives to closed-end funds there.

JackBW: As we near the end of our time, this question from DHill3656 seems apt.
Question: What areas of the market do you feel provide the best opportunity?

TmHerzfeld: For closed-end funds, CASH!

JackBW: Jeff has a final question for Tom Herzfeld.

JeffBW: Tom, are you just leery about the closed-end market, or the market in general?

TmHerzfeld: I'm quite concerned about overvaluations in the stock market, and I typically go into the fourth quarter in a heavy cash position to take advantage of wide discounts in December caused by yearend tax selling.

JackBW: That's a wrap for tonight. Thanks for being with us, Tom Herzfeld, and thanks for your insights into closed-end funds. And thanks, Jeff Laderman of BW, author of BW's Guide to Mutual Funds.

TmHerzfeld: You're quite welcome. I enjoyed it very much!

JackBW: Thanks to the audience for the sharp questions. Be sure to visit BW Online's Mutual Fund Corner, via the BW Plus! icon on our opening screen. Transcripts of this conference will be available soon -- look under Talk & Conferences. Thanks again, and goodnight to all!

Copyright 1996 by The McGraw-Hill Companies, Inc. All rights reserved.