How to Profit from Closed-End Funds

	Paul Tracy Street Authority.com
Special offer from StreetAuthority.com: Winning picks are up 242%, 189% and 135%. FREE Report--HIGH-GROWTH GAINS FROM LOW-TECH STOCKS.

On March 21, 1924 three Boston businessmen pooled together $50,000 to form a company called the Massachusetts Investor's Trust. The purpose of the company: to invest in the roaring 1920s stock market boom.

These three men unwittingly gave birth to a financial revolution. In fact, in the ensuing 80 years their invention, the mutual fund, has come to dominate the retail investing landscape.

From those humble beginnings, mutual funds have grown into a dominant force in the U.S. investing landscape. As of July 2005, total assets in U.S. funds totaled nearly $8.5 trillion dollars, a number equivalent to more than three-quarters of U.S. Gross Domestic Product (GDP).

But while mutual funds are enormously popular, there's another lesser-known type of fund that's been around even longer. This variety of fund has been in existence since at least mid 19th century Britain. But with only $371 billion in assets in the U.S., this phantom fund class is only about 5% the size of the mutual fund industry. Nonetheless, the group holds several major advantages over mutual funds. Even better, due to a quirk in the way these funds trade, investors periodically have a chance to buy great assets at a big discount (more on this topic in a moment).

The Good and Bad of Mutual Funds
There are some good reasons for mutual funds' popularity. For one thing, mutual funds allow individual investors to diversify their holdings efficiently with a relatively small sum of cash. Many individual mutual funds routinely hold several dozen or even several hundred individual stocks. Therefore, with a minimum initial investment of usually no more than a few thousand dollars, a mutual fund investor can take ownership in a large basket of companies.

And, of course, mutual funds have the benefit of economies of scale. Managers have access to expensive research, can trade in large blocks at ultra-low commission rates and can afford to hire a staff to constantly monitor their positions. Few individuals can afford that type of quality research as well as that commitment to daily research.

But mutual funds aren't perfect. In fact, they come with the following unique set of disadvantages:

-- Mutual funds only trade once per day. As such, investors can't buy and sell mutual funds shares during a trading day but must instead wait until the end of the day and accept the price offered at that time.
-- Mutual funds can be difficult to buy. Not all brokers allow access to all mutual fund families. Investors may well have to call and make arrangements with several fund families to invest their cash.
-- Mutual funds can be costly. Some funds charge an up-front sales charge of as much as 5% of the amount invested. Others charge an early redemption fee for taking money out of the fund before a specified period of time. And still other funds charge hefty 12b-1 marketing fees -- basically a fee used to help the fund family attract new investments.
-- Mutual fund managers must cope with constant new investment and liquidations. Each and every day, some investors take their money out of a mutual fund while others invest new cash. If there's a net cash infusion, then managers must put that money to work regardless of market conditions. And if there's a net redemption, then managers must sell off assets (stocks and bonds) to fund the disbursement. What's worse, statistics show that massive redemptions often come near major lows, just when it may be most profitable to buy stocks.
-- Mutual funds usually have minimum investment requirements. Mutual fund minimums can be as low as $500 or as high as $25,000 or more. High initial minimum investments may well impede investors from getting into the fund of their choice.

Enter Closed-End Funds
This long list of drawbacks is enough to deter some investors from investing in mutual funds altogether. However, there's a solution to many of these problems -- closed-end funds.

There are only about 800 closed-end funds in the U.S., and these funds boast less than $400 million in assets. That compares to roughly 8,000 U.S. mutual funds with close to $8.5 trillion in assets. However, despite their lack of popularity, closed-end funds could make valuable additions to just every investor's portfolio.

Unlike mutual funds, closed-end funds are listed on one of the major exchanges -- in most cases, the New York Stock Exchange (NYSE). You can buy shares in a closed-end fund directly from your broker, and when doing so, you can generally expect to pay the same commissions you'd pay to buy a normal stock off the exchange. There are no up-front sales fees or fees for early redemptions. Better still, closed-end funds trade throughout the normal 9:00 AM to 4:30 PM ET trading day, so you can buy and sell shares in a closed-end fund at any time you wish.

And, of course, there are no minimums. You can buy closed-end fund shares in any amount you desire. Many are highly liquid and trade hundreds of thousands of shares every day. When purchasing a closed-end fund you can buy as little as a single share or many thousands of shares if you'd like.

Closed-end fund managers also don't have to cope with the constant influx and redemption of cash investments. When a fund lists on the exchange, it raises a certain amount of capital just like a normal stock in an initial public offering (IPO). Investors in a closed-end fund can't ask for their investment back -- they can only buy and sell their shares in the open market. Transactions in the open market don't affect the actual cash the company has on hand to invest.

This means that closed-end fund managers essentially have a fixed pile of cash to work with. They don't have to cope with the daily inflows and outflows of cash that mutual fund managers do. As a result, their expenses and fees are typically much lower than for mutual funds -- often as low as 0.75% of assets annually.

And, of course, closed-end funds offer many of the same advantages as mutual funds. These include instant diversification, professional management expertise and the lower trading commissions and research efficiency that comes with size.

Like mutual funds too, these funds offer investors a chance to invest in many different strategies, regions and industries -- some funds focus on particular international markets, different classes of bonds or specific strategies such as income investing. In fact, one of the big benefits of closed-end funds is that they can give investors access to foreign markets and global bonds that would be very difficult for individual U.S. investors to buy directly.

A Profitable Quirk
There is one major feature of closed-end funds that all investors should be aware of. This feature, if fully understood, can offer advantages to the astute investor. However, if not taken into consideration, it can be detrimental. Specifically, I'm speaking of the concept of premiums and discounts.

Closed-end funds trade on the major exchanges just like stocks. Their price is determined not by the value of the investments they hold but by the supply and demand for each fund's shares. Let's illustrate with a simple example: suppose you hold a closed-end fund that owns 100 shares of IBM trading at $100 per share. The value of that investment is $10,000. This figure is called the net asset value (NAV). Furthermore, let's assume that the closed-end fund in question has a total of 1,000 traded shares. In this particular example, the fund's NAV per share would be $10.

However, just because the fund's investments are worth $10 per share does not necessarily mean that the closed-end fund trades at $10. If investors sell the fund's shares en masse, then the price of the fund on the market could well drop to $9 -- in this case, the fund would be trading at a 10% discount to its NAV. On the flip side, if investors, caught in a bullish mood, decide to buy the shares with abandon, then the fund could trade up to $11 or $12 per share. In this type of situation, the fund could sell at a premium to its NAV.

Although it might seem as though closed-end funds should trade at or near their NAV at all times, in practice this is definitely not the case. In the past, I've seen funds trade at premiums or discounts of more than +/- 20% of NAV for short periods of time. Over the long term, however, closed-end shares do tend to revert to their NAV. In some cases, in fact, closed-end fund management companies will try to speed up that adjustment by actually buying back their own shares if they're trading at a discount to NAV. Meanwhile, some hedge fund managers have been known to actively short-sell closed-end funds that are trading at big premiums to their NAV.

It's a good idea to try to buy funds that are trading either at discounts to their NAVs or at levels very close to their NAV. If you can buy a fund at a discount, then you're essentially buying that fund's assets -- the stocks and bonds held by the fund -- at a bargain price. In this case you stand to profit if and when that discount window is ultimately closed. On the flip side, as a general rule of thumb, funds that are trading at premiums of 3% or more to their NAV should be avoided.

In the table below, I list a number of promising closed-end funds, some basic information about these funds and their current premium or discount to NAV. And in the text that follows, I briefly outline eight of my favorite closed-end funds, many of which focus on a variety of unique strategies.

Morgan Stanley Emerging Markets Fund (MSF, $20.53)
Over the past few years, emerging market economies like China and India have delivered economic growth far superior to that shown by more established economies such as the U.S. and Japan. While the U.S. economy is the largest in the world, it's clearly mature -- long-term GDP growth of between 3% and 4% is about the fastest sustainable growth that can be expected here in the U.S. By contrast, the Chinese economy is growing at close to +10% on a trailing twelve-month basis, while India is up more than +7% over the same period. In these countries, a growing middle class is just starting to power consumption and foreign companies are investing to take advantage of this explosive growth.

The Morgan Stanley Emerging Markets Fund seeks to take advantage of these trends by investing in the most promising companies throughout a variety of emerging markets. The fund's assets are invested in countries like South Korea (12.44%), Taiwan (12.2%), Brazil (11.6%) and Mexico (10.5%), all of which represent promising markets for the long term.

I also like some of the fund's top holdings, such as Russia's Lukoil, one of the world's largest oil and gas companies. Meanwhile, the fund is also invested in Asian banking powerhouse Standard Chartered Bank Group -- a company that's sure to take advantage of rising demand for financial services from the fast-growing Asian middle class. Even more obscure is MTN Group -- one of the largest mobile phone operators in sub-Saharan Africa.

Morgan Stanley Asia-Pacific Fund (APF, $13.91)
If you're looking for an even more direct play on Asia's bright future, then Morgan Stanley's Asia-Pacific Fund could fit the bill. The fund's main holdings are located in Japan (48.3%), Hong Kong (10.2%) and Australia (9.8%).

Japan isn't a big growth story, but it is an attractive market just the same. The nation's real estate market is finally in recovery mode after 15 years of steady deflation. Better still, Junichiro Koizumi, the nation's prime minister, has pushed much-needed reforms through the country's Diet (legislature). Top holdings such as Matsushita Electric, the maker of Panasonic, and Canon are benefiting from an improved Japanese economy.

Australia is also a key Asian market. The nation is endowed with an abundance of natural resources, including oil, coal, natural gas and iron ore. These resources are increasingly finding ready markets in countries like China and India -- these energy and raw material-hungry countries simply need natural resources to grow. Among the world's largest miners, Australia's BHP Billiton should benefit handsomely.

Latin America Discovery Fund (LDF, $24.85)
The Latin America Discovery Fund offers diversified exposure to Latin America. Key nations in the region such as Brazil, Chile, Peru and even Argentina have seen solid growth in recent years. Brazil and Peru, for example, have benefited from positive government reforms and greater fiscal discipline. Both nations have also recently concluded several free trade deals with the U.S. to open up their markets.

Meanwhile, Argentina is finally recovering from its long malaise prompted by the collapse of the Argentinean peso early in the decade. Consumer spending power is on the rise in the region, as is foreign direct investment.

Better still, many Latin American countries boast an impressive array of natural resources, including oil, gas, copper and iron ore. Increasingly, China has been a ready market for these goods.

Top holdings in the region are concentrated in the financial industry. Banks are among the first major groups to benefit from economic growth and development. As consumers become wealthier, they'll need access to basic deposit and savings services as well as mortgage lending, credit cards and business loans. Many of the individual holdings within LDF will benefit from these activities.

Central Europe and Russia Fund (CEE, $40.00)
Central Europe is one of the world's most promising emerging markets for two reasons: tremendous growth potential from still developing economies and the safety and security that comes with being part of the EU. On the first count, most Eastern European economies, even the most developed countries like Hungary and the Czech Republic, still aren't nearly as developed as countries like France and Germany. Consumers in these nations are just discovering basic financial services and spending power is growing thanks to rising incomes and foreign investment. The EU is closing the income gap by investing massive amounts of money in the East.

And while these countries are emerging market growth stories, they aren't quite as risky as nations in many other areas of the world. For starters, they're required to follow certain fiscal and monetary guidelines imposed as part of EU entry. And eventually most are scheduled to enter the euro currency. As a result, foreign investors are all-but assured that currencies will remain relatively secure and governments in the region stable. For these countries, euro entry brings the benefit of reduced funding costs -- due to the inherent stability of the euro, eastern European countries are able to secure very favorable interest rates on bond issues.

With these factors in mind, this fund's investments in countries like Hungary (10.9%), Poland (20.9%) and the Czech Republic (6.8%) are highly attractive. Meanwhile the fund is nearly 50% invested in Russia. Russia is a key supplier of basic energy commodities; better still, the country is undergoing key economic reforms of its own.

Europe Fund (EF, $11.66)
The Europe Fund, managed by Merrill Lynch, invests in more mature European markets. While Western Europe can't offer the growth potential available in the East, there are advantages to the region. For example, dividend yields in mature European economies tend to be much higher than in the U.S. As a result, this fund yields nearly 7.0%.

And in an increasingly globalized world, European companies, much like their U.S. counterparts, tend to operate in many different markets. Most Americans recognize major European brands such as Holiday Inn hotels, Perrier bottled water and Nestle chocolates.

The Europe Fund has solid positions in several high-yielding European banks such as Britain's Lloyd's TSB and the Netherland's ING Group. Other key holdings include alcoholic beverage makers Diageo and Pernod Ricard, as well as luxury goods manufacturer LVMH (Louis Vuitton).

Seligman Select Municipal Fund (SEL, $10.45)
As I explained in my August 29th, 2005 Market Advisor issue, in addition to decent returns, municipal bonds offer major tax advantages, especially for investors in the top income tax brackets.

The Seligman Select Municipal Fund invests in such tax-advantaged bonds, passing on coupon payments to investors in the form of a monthly distribution. The company only invests in higher-quality investment-grade muni bonds. Currently, the fund offers a yield of about 5.5%.

The real benefit of the fund is that it trades at a discount of about 12% to its net asset value (NAV). That means you're buying the underlying bonds in the fund at a discount to their current resale value.

Eaton Vance Tax-Advantaged Global Dividend Fund (ETG, $20.63)
Eaton Vance Global Dividend doesn't limit itself to the U.S. markets in searching for yields. The fund has just under half of its total portfolio invested in U.S. securities. Meanwhile, the rest are drawn from Europe and Latin America.

And the fund doesn't invest exclusively in common stocks, but instead prefers a mixture of preferreds, bonds and common equities. And to help boost overall returns, this closed-end fund also employs leverage -- borrowing money to increase its position sizes and boost returns.

By investing in a diversified basket of overseas income stocks and preferreds, Eaton Vance lowers overall risk while offering outstanding income potential. The current yield on the fund is close to 7%.

Scudder Global High Income Fund (LBF, $8.18)
Along the same lines as the Eaton Vance fund is the Scudder Global High Income Fund. This fund also scours the global markets for yields. But unlike the Eaton fund, Scudder invests almost exclusively in foreign bonds -- about 87% in foreign government bonds and the balance in foreign corporate bonds from investment-quality issuers.

While the 10-year U.S. government bond yields around 4% right now, some foreign bonds yield many times that amount. In addition, as countries improve their fiscal discipline and see solid economic growth, their bonds tend to rally in price. As such, these bonds offer room for capital gains as well as income. Scudder invests in some of the world's most promising, highest-yielding markets such as Brazil, Russia, Turkey and Bulgaria. The fund currently yields about 7%.

High Income Opportunity Fund (HIO, $6.60)
Managed by Citigroup, the High Income Opportunity Fund is a slightly riskier pick. However, that higher risk does translate into a higher yield -- currently close to 8%.

This fund invests mainly in corporate bonds of U.S. companies. However, the fund tends to focus on the high-yield "junk bond" market -- investing in bonds from issuers with non-investment-grade credit ratings. Such issuers carry a higher incidence of default, meaning they're more likely to be unable to pay their debts. However, these bonds also offer much higher yields.

By diversifying holdings across an array of different industry groups and issuers, Citi is able to mitigate risks; if a single issuer defaults, then the fund won't lose its shirt.

----------------------------
I sincerely hope you've enjoyed today's look at a variety of promising closed-end funds. Please stay tuned for my next full issue, which I'll publish on Monday, September 26th. In it, my staff and I will show you how you can learn -- as well as profit -- from some of the world's most successful fund managers. Good investing in the week ahead!

Paul Tracy will be available to take your questions until Thursday, September 22. Please use the form below to submit your questions.