They invest like mutual funds but trade like shares of stock. Lately, they have become the hottest way for people to invest in the economies of fast-growing foreign countries. We're talking about ``closed end'' mutual funds, which have been spinning out of brokerages, money management companies, and investment companies at a fast pace in the last year or so. The new closed-end funds are helping investors take advantage of specialized niches in this country and to put money in countries where it might otherwise be difficult to invest, like South Korea.
There are just over 85 closed-end funds in the United States, and they get their name from the fact that their sponsoring companies do not issue new shares every time new money is mailed in -- unlike the far more common open-end funds, which stand ready to issue and redeem shares on a continuous basis. Like a corporation, closed-ends have a fixed number of shares. If you buy a share of a closed-end fund, that means someone else sold a share.
Closed-end funds have two other characteristics, which seem to conflict but actually make them more attractive to sophisticated investors:
1. Management is not concerned with continuous buying and selling of stocks to accommodate new investors and redemptions. As a result, management can buy and sell stock when it wants to, basing decisions on the market and the price of the particular stock.
2. The popular perception, however, is just the opposite. Many people believe closed-end fund managers have less flexibility than those who work for open-end funds. As a result, closed-ends, which trade on national and regional stock exchanges, often sell at prices below their net asset values, or NAV.
This difference is called a discount, and it is a key reason that many people invest in closed-end funds: They can buy a share of it for less than the share is worth. Looked at another way, the price of the fund is less than the value of the stocks in its portfolio.
Another reason these funds sell at a discount is that they're not too popular in the brokerage houses. An open-end fund with a full load can pay a broker as much as 8.5 percent commission. The average commission on a closed-end fund is only about 1.5 percent.
Lately, however, several closed-end funds have been selling at very narrow discounts or even premiums, where their selling price is more than the NAV.
``When a fund sells at a premium, it's an indication of some public appeal for that fund,'' says Norman Fosback, editor of the Mutual Fund Forecaster, a Fort Lauderdale, Fla., newsletter. ``But the only time you should pay a premium is when you expect the fund to grow at a better-than-average pace.''
``If you see a fund selling at a premium, the probability is that you can find a fund with a similar portfolio selling at a discount,'' says Thomas J. Herzfeld, whose South Miami, Fla., brokerage firm specializes in closed-end funds.
That may be true, but some closed-end funds seem to have generated enough interest to demand hefty premiums.
Earlier this month, the Korea Fund was selling at a 49 percent premium; the Italy Fund's premium was 7.7 percent; the First Australia Prime Income Fund was at a 18.3 percent premium; and the price of the Z-Seven Fund was 18 percent over its NAV.
Investors in these funds apparently felt the NAV would eventually catch up with the price they paid, or the funds' earnings would make up for the premium. Both things may happen; then again, they may not.
``We've been selling at a premium since February,'' says Gary Shiffman, president of the Z-Seven Fund, where the premium has been as high as 48 percent. ``We like it that way. We see ourselves more like a growth-company stock.'' The fund gained 40 percent in 1984 and 37 percent last year, Mr. Shiffman says.
Another reason Z-Seven likes the premium, Shiffman explains, is that this prevents it from being ``open ended.'' This can happen to a discount-selling fund when a majority of shareholders, perhaps out of dissatisfaction with management, votes to turn the fund into the open-ended variety. The fund's shares can then be sold at their present NAV, so if it has been selling at a discount, this gives shareholders an immediate gain.
While strong performance is one reason for a premium, it may also be justified when a fund specializes in an area that would otherwise be hard for investors to get into. The best example of this is the Korea Fund, which is one of the few ways to get into that country's tightly controlled securities market.
The Korea Fund's success has helped bring a flock of single-country closed-end funds to the market, including funds specializing in Scandinavia, Italy, France, and West Germany. Soon there will be an Asia Pacific Fund.
If you think the stocks of these countries will gain enough to offset any premiums, or that the fund managers' track record is good enough to justify the premium, then these funds may be worth considering. Otherwise, you get an instant bargain when you buy a closed-end fund at a discount.
But how much of a discount should you get?
It depends on several things, Mr. Herzfeld says. A fund's overall performance, expense ratio, and quality of its portfolio should all be considered. But assuming all things are equal, a fund's discount should be about 5 percent lower than the previous year's average. ``If the average discount was 7 percent last year, buy it at 12 percent,'' he recommends.
Unlike many open-end funds, all closed-ends have to be bought through a broker, though you can save on commissions with a discount broker. In addition to this commission, there is an annual management fee averaging between one-half and 1 percent of the investment.
Current prices of closed-end funds are included in the listings of major stock exchanges, and Barron's provides a list of the funds with their discounts or premiums.
If you have a question that would make a good subject for this column, please send it to Moneywise, The Christian Science Monitor, One Norway Street, Boston, Mass. 02115. No personal replies can be given by mail or phone. References to investments are not an endorsement or recommendation by this newspaper.