5 August 2005, Investment Advisor

When the bull market was peaking in the late 1990s, new issues of closed-end funds virtually dried up. According to Thomas J. Herzfeld Advisors, a Miami-based closed-end fund specialist, only one closed-end fund came to market in 2000, raising just $300 million. This led many market observers to suggest the industry’s demise. That call, however, turned out to be greatly exaggerated.

Ironically, it was the subsequent collapse of stocks and interest rates that revived this moribund industry. A new generation of closed-end funds began targeting investors looking for steady income streams.

In 2001, 37 new closed-end funds came to market, led by municipals, raising nearly $6 billion. In 2002, 79 issues worth $16 billion were issued, buoyed by a new-found interest in preferred stock funds. Then 2003 and 2004 averaged 50 deals a piece, boosted by more preferred funds and alternative equity products, including covered call products, generated about $26 billion, respectively. And according to Cecilia Gondor, executive vice president at Herzfeld, this year promises to continue the pace. During the first half of 2005 alone, there were 31 deals worth more than $14 billion.

Does that mean the industry’s structural anomalies, which have troubled investors, have disappeared?

No. Their market values will always deviate, sometimes significantly, from their net asset values. This is unlike open-end funds where every dollar you invest [less any acquisition and managerial expenses] actually gets you ownership into a dollar’s worth of the fund’s securities.

Take the closed-end China Fund, which on 22 July 2005 was trading for $28.77 per share. But its underlying securities were worth only $25.44. That meant new investors were paying a 13 percent premium to get into the action. And good action it’s been. Over the past year, the fund’s market value appreciated 29.2 percent, according to Barrons’ weekly listings of closed-end funds. However, according to Lipper, Barron’s data source, the fund’s premium had soared beyond 41 percent late last year. So if you had bought shares in December, you’d be deep in the red.

But this deviation between NAV and market value [MV] can work in investors’ favor. Take the Korean Equity Fund, which rose 46.5 percent over the last 12 months. During that time, it has seen its discount of more than 14 percent decline below 6 percent. In fact, the fund has been enjoying a long-term improvement in the discount which peaked in November 2001 at more than 21 percent, but has been correcting ever since, providing investors with extra octane.

To help attract underwriters as well as investors, many closed-end funds committed themselves to managed distributions–a regular payout, measured as a percent of NAV, which topped out as high as 10 percent.

Certainly the concept is attention grabbing. However, it doesn’t take an MBA to realize that such funds could suffer from capital erosion to meet such commitment. But some funds and their shareholders have actually thrived under such arrangements.

Take the Blue Chip Value fund, which started up in 1987 with an NAV of $9.27. It subsequently adopted a managed distribution of 10 percent. According to Don Cassidy, senior analyst at Lipper, the fund’s NAV had declined to $5.64 as of the end of June 2005. However, because of the fund’s ability to meet its managed distribution, aided through leverage, and helped by a premium that now stands at 14.6 percent, the fund’s historic annualized returns exceeds 9 percent.

Closed-end funds also earned a sour reputation from the financial hit investors almost always take when buying initial public offerings of a fund. While distribution fees have come down a bit since the 1990s, Michael Porter, senior research analyst at Lipper in New York, explains that the typical closed-end fund coming to market at $20 will see its initial net asset value set at $19.10 because the underwriters are taking a $0.90 fee.

“How IPOs can still be sold under this arrangement,” queries Porter, “is the million dollar question.” But he believes that the recent revival in closed-end funds, despite the quirkiness in which they first come to market, is due to new income-oriented products that are offering investors intriguing alternatives to traditional investing, which otherwise would be difficult to come by. And a key means that helps them achieve these above-market income flows is leverage—a feature unavailable to open-end funds.

Leverage is achieved when a fund borrows against its assets. While the degree of borrowing varies widely, it is typically around 30-35 percent. This means funds can have a third more income-producing assets working for it, which can transform a 4.5 percent-income security into a 6 percent yield.

This year has seen the issuance of multi-strategy funds seeking to deliver steady income flows. They rely on various strategies, many of which are available as individual funds discussed below.

Master Limited Partnerships

Alex Reiss, a senior closed-end fund analyst at Ryan Beck & Company, with $18.5 billion of assets under management, believes that while closed-end funds are not a distinct asset class, they should be looked at as a means of improving allocation strategy. For instance, he’s keen on Master Limited Partnerships to enhance energy exposure. “They aren’t bets on commodity prices,” Reiss explains, “but investments in gas and oil pipelines and other energy infrastructure that generates toll-like revenue as resources flow through them.” Current yields average 6 percent, but total annualized returns have been eye-popping.

According to Morningstar, Energy Transfer Partners, with a market cap of $3.52 billion, has generated annualized returns of nearly 40 percent over the past five years through the first half of 2005. Magellan Midstream Partners, with $2 billion in assets, was almost as good, producing yearly returns over 33 percent over the same time frame.

Corporate Loan Funds

Mariana Bush, closed-end fund specialist at Wachovia Securities in Washington, D.C., likes prime rate, a.k.a., corporate loan funds, which are made up of debt issued by below-investment-grade companies. “But they are generally more secure than high-yield bonds,” Bush explains, “because they are higher up the capital structure than bonds, i.e., first-lien loans will be paid off ahead of nearly all other debt.”

Further, their NAVs are generally less volatile than high-yield debt because their income adjusts on average every two months. Dividends are based on 30-day LIBOR plus 200-400 basis points—depending on credit quality.

Loan funds were trading up to a five percent premium in early 2005 as costs of borrowing remained relatively inexpensive, portending the bottoming of default rates at 2.2 percent in May. However, Moody’s believes that default rates will moderately rise over the next several years as the cost of borrowing increases along with the Fed Funds rate. This has helped transform premiums into discounts that are ranging down to nine percent as of the end of June.

Bush believes institutional selling has also driven down market prices as money managers liquidated carry trades that are proving less profitable as short-term rates rise. But she concludes that “while increasing defaults may push down NAVs, investors should be rewarded by rising yields as short rates continue to increase, boosted further by discounted pricing.”

Among the more attractive loan funds, says Bush, is the $1.46 billion Van Kampen Senior Income Trust. Unlike other prime-rate funds, this trust invests exclusively in first- lien loans, which Bush believes will outperform higher yielding lower structured debt during a rising rate environment. Accordingly, it doesn’t have the highest yield [6.2 percent] or three-year annualized returns [10.8 percent] as some other funds. But it has very low volatility [5.8 percent], below-average expense ratio of 1.59 percent, and is trading at a 5.7 percent discount, which collectively help mitigate risk.

Covered Call Funds

With the broad market having been largely range bound over the past couple of years, covered call funds have been considered by many observers a conservative way of drawing a steady flow of income out of a market that can’t make up its mind which way it wants to go. While these funds date back to the 1980s, the current universe is composed of 23 funds issued over the past 14 months. In the first half of 2005, underwriters raised $10.7 billion with more funds in the pipeline.

Typically, a covered call, or buy-write, fund will go long stocks and then sell short-term call options on shares or an index. The good thing is that such funds are generating yields averaging between 8-10 percent–even when the market heads south. The bad thing is that if stocks start to run, as they did in July, the fund’s upside will be limited to the premium income as shares get called away.

Being relatively new, these funds don’t offer much historical data. The oldest fund, the $270 million Madison/Claymore Covered Call Fund, was started in July 2004. It has a current yield of 8.3 percent, and through the first half of 2005, it has generated a return of 11.6 percent as investors have pushed its market price to a 6.4 percent premium.

Preferred Stock Funds

While preferred stock funds date back to the late 1980s when dividend received deductions [DRDs] enhanced the total returns for qualified investors, the retail versions took off in June 2002 as 10 funds came to market over the proceeding 12 months, raising $7.7 billion. An additional $3.7 billion was raised by another three funds with more than half their assets dedicated to preferred shares.

The reason for this rediscovered interest in preferred stock was made clear as the bear market sunk its teeth in and interest rates started to descend. Preferreds were offering above-market yields through conventional means and with only slightly more risk than senior bonds. And in a number of instances, they involved the same risk as bonds in that they were actually bonds wrapped in a preferred veneer.

While the non-DRD funds also have too short a history to discern their viability, so far they have racked up attractive one-year returns through the end of June, led by BlackRock Preferred Opportunity Trust and Nuveen Quality Preferred Income Fund 3. Their total returns of 19.3 and 13.2 percent, respectively, were supported by price yields of around 8 percent and reduction in their discounts. They are about one-third leveraged, have below-average volatility of 10.6 percent, with expense ratios that are a bit above the industry average of 1.35 percent.

Global REITS

REITs are nothing new. But in the closed-end fund world, their increasingly international make up is. James Corl, CIO of REITs at Cohen & Steers, explains that more foreign countries are permitting the creation of REIT-like structures. “This helps us diversify our holdings and income streams,” he explains, “protecting investors by gaining exposures to economies that are in different economic cycles. Even more compelling, they avails us to significant gains that accrue from when real estate companies convert into REITs.”

He points to the French experience in 2003 when the country legislated creation of REIT-like structures. Before the rule change, the bulk of real estate companies were trading at more than a 20 percent discount to their NAV. By early 2005, they were trading at a 25% premium. This shift was largely driven by multiple expansion in dividend payouts, as investors gravitated to the securities’ attractive income streams.

There is plenty of potential left in the global market for capturing more of this conversion premium. According to Corl, before 2000, only four developed markets had REIT-like structures. Since then, Japan, Korea, France and Hong Kong joined the list. And currently, Germany, Italy, Spain, the UK, and Finland are considering adopting such measures.

Two global closed-end real estate funds came to market since last year. ING Clarion Global Real Estate Income [IGR], which IPOed in February 2004, has a current yield of 7 percent and a one-year total price returns through August 2, 2005 of 35.3 percent. It currently trades at a 12.4 percent discount. Cohen & Steer’s Global Real Estate fund [RWF] came to market in March 2005, offering a current price yield of 7.5 percent. Over the past three months, it has generated total returns of 8.72 percent and trades at a three percent premium.

TIPS

Treasury-inflation-protected securities have gained popularity over the past several years as a means for investors to secure real yields through debt that regularly adjusts for inflation. Increasing demand has also produced capital gains for many of these securities. Over the past two years, three TIPS funds have come to market with total assets worth more than $1.4 billion. Western Asset/Claymore issued two of the three funds [WIA and WIW], which currently offer yields of 6.13 and 7.88 percent. But expanding discounts, both currently around 9 percent, have eaten away at total returns over the past year through July, bringing them down to 3.31 and 6.71 percent, respectively.

Foreign Funds

While these shares have been around for a while, the past 12 months has witnessed some extraordinary performance [in US dollar terms] as investors have sought out more remote opportunities where improving economies and regulatory conditions are attracting foreign capital. While such returns are unsustainable and are poised for correction, a quick sampling from the July 22nd issue of Barron’s tells the story. Further, when comparing performance with MSCI country indices, we’re also seeing most managers delivering significant value.

Despite such performance across much of the globe, double-digit discounts can still be found. But to Thomas Herzfeld, this can spell opportunity. Over the past several years, he observed that the discount on the profitable Koran Equity Fund [KEF] was steadily improving from 20 percent back in late 2001. In March 2005, it turned into a premium. But within two months, the fund reverted to a discount exceeding 10 percent. Expecting the discount to correct and wishing to avoid equity exposure, Herzfeld went long the fund and shorted the corresponding South Korean i-Share. “This made our play market neutral,” he explains, “and enabled us to pick up five percent by July as the discount closed.”

If closed-end funds sound like they ought to have a place in your clients’ portfolio, George Cole Scott, president of the Richmond, Virginia-based Closed-End Fund Advisors, with $__ million of assets under management, suggests first identifying the asset class to which you’re looking to add. Then discern management’s ability to exploit opportunities and manage risk. Determine whether the fund regularly outperforms its benchmark. Review its leverage and overall volatility. He focuses on funds that have good relationships with investors and Wall Street. If everything looks in order, see where the shares are trading relative to their NAV. It takes an extraordinary offering to attract Scott into a premium-priced fund, especially when an ETF can provide comparable exposure.

But if he discerns that a fund’s discount has disconnected from the quality of its underlying assets, he may see opportunity in buying a $1 worth of assets for $0.75 to $0.80. And while there’s nothing that will guarantee a discount will correct nor expand further, Scott’s observing increasing evidence of shareholder activism that’s forcing management to correct protracted, deep discounts through share repurchases, enhanced distributions, and even replacement of investment advisors. “This improving oversight,” Scott believes, “should help address an industry weakness that in the past has turned investors off from participating in some unique opportunities now being offered in the closed-end fund world.”