Go Global With Closed-End Funds

Despite this year's turbulence in world markets, returns on international stocks over the past several years have been red-hot. As measured by Morgan Stanley's MSCI-EAFE index, which includes stocks in developed countries around the world, international stocks have returned an average of more than 12% annually over the past five years in U.S. dollar terms. If you expand your scope to include stocks in emerging-market countries such as China, India, Russia, and Brazil, you'll find other MSCI indices returning more than twice those of the MSCI-EAFE index.

Closed-end mutual funds are one way to own shares in foreign countries. Like exchange-traded funds, closed-end funds trade on stock exchanges, rather than being purchased directly from the mutual fund company. Unlike most exchange-traded funds, however, many closed-end funds have actively managed portfolios that fund managers can modify on an ongoing basis to react to changing market conditions.

Why closed-end funds?
High-flying international market returns have prompted an explosion in the number of ways to invest globally. Many foreign companies list their stocks directly on U.S. stock exchanges, making them available to anyone with a standard brokerage account. A number of exchange-traded funds, such as iShares' series of index-tracking country funds, give investors broad exposure to a range of companies within a particular country. Mutual fund inflows into international funds have been extremely high in relation to money going into domestic stock funds.

Because of all of the ways in which you can participate in the booming international stock market, you may wonder how closed-end funds distinguish themselves.

In the global arena, closed-end funds have several advantages over other kinds of investments. Closed-end funds offer both investors and managers a chance to work with each other under favorable conditions, in comparison with traditional mutual funds. At the same time, the opportunity to buy shares at a discount can make closed-end investing more lucrative.

Access to efficient fund management
For investors seeking active management of their investments, international closed-end funds sometimes represent the cheapest way to gain access to a particular fund manager. For example, Franklin Templeton fund manager Mark Mobius has won a number of awards for his work in managing investments in emerging markets around the world. If you want to invest in the traditional mutual funds he manages, however, you'll probably have to pay a sales load of as much as 5.75%. On the other hand, you can buy shares of closed-end funds he manages, such as Templeton Dragon Fund (NYSE: TDF  ) or Templeton Emerging Markets Fund (NYSE: EMF  ) , for no more than the cost of your purchase commission.

Closed-end funds' structure makes them easier to manage than traditional mutual funds. Because investors in traditional mutual funds can buy or sell shares at any time, the managers of those funds must constantly deal with flows of money going in or out of their funds and adjust their investing portfolios accordingly. When too much money comes in at once, managers may find it difficult to locate enough suitable investment opportunities. Because many foreign stock markets have significantly less liquidity than investors are used to seeing in the United States, this problem is of particular concern to international fund managers. On the other hand, if money is flowing out of the fund, fund managers may have to liquidate assets, even if they believe that those assets would perform well for their investors.

Closed-end fund managers, by comparison, don't have to worry about money flowing in or out of their funds. Once the public offering of closed-end-fund shares is complete, transactions involving shares of closed-end funds occur solely in the secondary market, with absolutely no effect on the fund or its assets. Managers can focus on the money they have, knowing that it is all that they may ever have to invest for their shareholders.

Discounts on closed-end funds
The other primary advantage that some closed-end funds have is that they may trade at a discount to the value of the assets they own. With funds focusing on international stocks, it's not uncommon to see discounts of 10% or more.

However, don't expect to see discounts on every international closed-end fund. Because investing in some international markets can be extremely difficult, closed-end funds sometimes offer the only access to a particular country or region. For example, although many large Japanese companies have listed shares on U.S. stock exchanges, it's harder for investors to buy shares of smaller companies in Japan. As a result, the Japan Smaller Capitalization Fund (NYSE: JOF  ) often trades at a premium to net asset value, especially when investing in Japan is in vogue. Similar situations are visible in the shares of the Thai Fund (NYSE: TTF  ) , Thai Capital Fund (NYSE: TF  ) , and Indonesia Fund (NYSE: IF  ) .

Depending on what you're looking for in an international investment, closed-end funds are worth your consideration. In some cases, they offer the best way to focus your investment exactly how you want, while you get to retain the advantages of active asset management.

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This article, written by Dan Caplinger, was originally published on Jan. 29, 2007 and has been updated by Kristin Graham.

For more Foolish international investing ideas, including individual stock recommendations and advice on how to get the most from your investments overseas, try the Fool's Global Gains international newsletter free for 30 days. The Fool's disclosure policy is always open to you.

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  • Report this Comment On October 28, 2008, at 2:26 PM, sanserve wrote:

    Wall Street Garage Sale Produces Closed End Fund Bargains

    There's a bright light at the end of the tunnel--- finally. Most of the really well respected, long term investors are advising their audiences to hang in there, to stop the panic selling, and to look for the great companies that have withstood the economic downturns of the past.

    Buffet, Bogle, Gross, Schwab, and company offer sound advice--- don't run and hide, it's time to hit the Wall Street Mall and go shopping! They've seen the indicators; they've been there before. So have many of you. Clearly, it's time for action.

    With IGV stock prices down 50% or more, and income securities as low or lower, Chuck Jaffe points out in MarketWatch that the case for loading up on managed Closed End Funds (CEFs) is a strong one. The great companies are in garage sale mode, and managed CEFs are selling at an additional 25% below net asset value (NAV).

    Jaffe writes: "With investments, investors can only guess at how big a bargain they are getting. The one exception is CEFs, where investors looking for both bargains and income streams get a price tag that shows the actual amount of their discount--- an intriguing choice for current market conditions."

    Jaffe emphasizes that investors "look inside" the wide variety of CEFs out there, and there are excellent educational websites, like ETF Connect, for hands on research. He quotes investment manager Jerry Paul, who feels that "the buying case is pretty clear", and that "the best times for closed end funds have been in crisis environments".

    The CEF idea, in both equity and fixed income portfolios, boils down to this lightly edited commentary from an old friend that brainwashing book readers know as Deep Pockets: "Closed end funds are misunderstood investments and perhaps that is reflected in their volatility."

    "Seems to me that the leverage on the funds would be the cause of concern, yet the taxable funds like Blackrock are not leveraged yet seem to have the same volatility as the leveraged funds. Credit risk could be another cause of concern, yet the insured municipal funds seem to be as volatile as the uninsured."

    "As you have pointed out, overall income streams have been stable, yet double digit yields are all over the place. Fixed income assets are on SALE because of the decline in the bond market and thus the reduced net asset values."

    "Additional opportunity exists because the Market Values of CEF stocks are at huge discounts to their already lowered NAVs. It is like the 25% markdown sale items are reduced by an additional 25% for no reason other then fear and misunderstanding."

    "Looking at prior periods of panic in the markets, closed end funds historically have big rallies toward the end of bear markets. 2003 saw many closed end funds achieve returns of 25-30% in just twelve months. Those who locked in high rates during panic-selling enjoyed high income streams going forward, long after the markets turned up and current yields went down."

    Deep Pockets also believes that there are flickering beacons of hope out there for a rally to commence in both markets before too much more blood is shed by the faint of heart. Here are some bright lights to focus on:

    Light One: "The credit markets are beginning to thaw, with LIBOR rates coming down and commercial paper markets starting to function more normally. Some of the fear of systemic failure is abating"--- and the Fed cash infusion has not yet started.

    Light Two: "Oil prices are dropping back into normal ranges, increasing the purchasing power of consumers", and reducing the costs of getting goods to market--- but hopefully not enough to discourage conservation and US development efforts.

    Light Three: "The price of gold has fallen, a normal sign that fear and panic have lessened."

    Light Four: "The dollar has risen to multi-year highs against many currencies increasing confidence that we will lead the global recovery"--- no matter how bad you paint the picture, there's always a recovery.

    Light Five: "You just don't hear too much about inflation anymore"--- and prices just haven't fallen as they would if things were looking even worse.

    Light Six: "The few up days lately on Wall Street have inspired huge volume, while the volume on down days is falling"--- remember, buyers tend to hold on for profits down the road.

    Light Seven: "The 2009 P/E ratio estimates for S & P 500 companies are historically low."

    Light Eight: "Dividend yields on common stocks are historically high."

    Light Nine: One huge element of economic uncertainty will disappear in early November, and most would agree that this too has been discounted. Typically, the media will place more emphasis on good news during the honeymoon period.

    The rally is in your hands people, let's get out there and party! How? Buy back into your 401(k) value funds, add to your personal portfolios (particularly those high yielding income CEFs), and stop taking losses on solid, mainstream, dividend-paying companies.

    Steve Selengut

    Professional Investment Management from 1979

    Author of: "The Brainwashing of the American Investor: The Book that Wall Street Does Not Want YOU to Read", and "A Millionaire's Secret Investment Strategy"

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