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How to buy a closed-end fund

Dhirendra Kumar

Why own a closed-end fund when every fund company is floating a brand new open-end fund every other day?Because a careful buying can get you bargains. A lot of closed-end funds, holding many of the same securities as their open-end cousins, trade for as little as 70 paisa or a rupee.

But this is unlike getting a designer suit in a clearance sale at 30 per cent discount on the retail list price. After all, you may well face the same discount when you want to sell the fund. But other things being equal-- performance, expense ratios and yields-- a deeply discounted closed-end is likely to be a better buy than a comparable open-end fund.

Imagine that the UTI's open-end fund Mastergain has a portfolio worth Rs 100 a share and can be bought at Rs 100 while it can be sold at marginally less than Rs 100 a share. Now consider that the UTI's closed-end funds Mastershare or Mastergrowth has an identical portfolio worth Rs 100 a share, but its shares trade at Rs 70. Let's say both net asset values double to Rs 200. And assuming the closed-ends discount stays stubbornly at 20 per cent, when you go to sell the shares are trading at only Rs 160.

Apart from brokerage commissions, your capital gain is the same: In either fund you double your money. But wait. What if the portfolio throws off a Rs 20 dividend after expenses? That's a 20 per cent return on your investment in Mastergain, but a 29 per cent return at Mastershare. This yield effect boosts your total return on the closed-end fund.

How is it that a fund could have Rs 100 net asset value but trade at 80? It's very simple. Open-end mutual funds will buy your shares back on demand at asset value. Closed-ends won't, and you can sell them only for what other investors are willing to pay. If other investors are lukewarm towards them, they'll buy them only at a sizeable discount. Like now. Despite similar portfolio results, discounts have been widening.

Factors Influencing Discounts/Premiums:
Many funds consistently trade at, close to or around, a particular level of discount or premium. There may be many factors responsible for determining whether a fund will trade at a premium or discount, and how much the premium or discount will be. Changes to these factors may cause the discount or premium to adjust to a new stable level.

Ignorance: Perhaps the most important factor why most closed-ends trade at a discount is that now they operate in relative obscurity, and hence demand for their shares is low. While most investors hear so much about mutual funds, very few have heard about closed-end funds. And for obvious reasons, funds advertise extensively to attract investment money since the management is paid a percentage of the assets managed. However, closed-end funds, except under very rare circumstances, operate with a stable pool of investment money. Advertising will not increase the asset base; instead, the cost of advertising erodes the assets of the fund.

Performance: A closed-end that consistently under-performs the indices relevant to the fund will eventually trade at a discount as investors leave the fund and fewer investors buy into the fund. And conversely, a closed-end that consistently outperforms the indices and related funds will trade at a premium. However, in recent years hardly has any fund been traded at a premium with the exception of guaranteed return funds.

General Market Sentiment: The market sentiment plays a significant role in the premium /discount of closed-ends. When investors are particularly bullish, as was the case in 1992 and 1994 ,many funds traded at sharp premiums, some even in excess of 30 per cent premium. Similarly, when investors are particularly bearish, as was during 1995 and 1998, many of the same funds traded at wide discounts often in excess of 20 per cent.

Excess Supply: The introduction of new funds investing in the same markets tends to increase discounts since these new funds draw away money that would otherwise have been committed to the older funds. For example, the introduction of Mastergain led to a sharp drop in the premium of Mastershare in 1992 and Magnum Multiplier Plus in 1993 lead large discounts on the new fund besides the older fund, Magnum Multiplier 90.

Open-Ending: Funds that trade at excessive discounts and/or have an attractive portfolio may be under pressure to convert into open-end. So investors can buy large block and thereby profit from the disappearance of the discount. Depending on the time for open-ending, the discount may shrink or disappear. Watch the narrowing discount on Mastergrowth.

A few years can make a lot of difference. During 1992 and 1994 mutual funds foisted Rs 7,000 crore of new closed-end equity funds on investors. Investors happily paid brokers 7 per cent commissions, that is, they paid a bit more than Rs1.07 for a rupee worth of assets. By the end of 1993 the UTI's Masterplus and SBI's Magnum Multiplier sported 100 per cent and 150 per cent premiums, respectively. Now the UTI's Masterplus languishes at discounts of 30 per cent while SBI's Magnum Multiplier had to be converted into an open-end fund.

To succeed at this game, you've got to buy when everyone is selling. Now is a great time to buy. In choosing a closed-end fund, don't just look at past performance. Keep a close eye on discounts and quality of portfolio. As a rule of thumb, don't buy a fund unless it outperforms the relevant benchmark over the past three years.

The funds available on discount are rare species and will soon be extinct. These funds combine good discounts with performance ahead of a relevant benchmark over the past three years. Buy and hold, before you cannot.

Fund		Return (30/9/99)		Redemption	NAV	Price	Prem/
	3 Mths	1 Year	3 Year				Disc
Mastergrowth	20.22	40.04	28.00	04-2000	20.00	18.00	-10.00
Mastershare	19.57	46.49	26.88	10-2003	20.75	14.00	-32.53
Morgan Stanley G F	45.43	90.01	142.33	02-2009	18.49	10.60	-42.67
Zurich India Quantum Growth	19.76	69.52	127.48	01-2000	14.83	12.30	-17.06
ICICI Premier	15.48	33.59	61.97	02-2000	10.57	10.00	-5.39
ICICI Power	42.08	76.39	78.27	10-2002	14.42	12.81	-11.17

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