Big Bargains on Closed-End Funds

Shoppers eagerly wait for day-after-Thanksgiving sales to scoop up savings on holiday gifts. But for investors in closed-end mutual funds, the shopping season has already begun.

According to Lipper, the median discount on closed-end funds widened in October to 8.73%, the highest level since 2000. While those numbers reflect the turbulent market environment over the past several months, they may also give investors an opportunity to buy fund shares on the cheap.

A market of their own
With the explosion of exchange-traded funds into the marketplace, closed-end funds have largely faded into the background. But they have unique characteristics that make them an interesting gauge of market sentiment. ETFs and traditional mutual funds typically trade close to the value of their assets. So if you own an ETF that tracks a stock index and that index falls 1%, the ETF will almost always fall by that same 1%.

Closed-end funds, on the other hand, often trade at a significant discount or premium to the value of their assets. One reason for the disparity is related to investor interest; funds in popular sectors tend to have smaller discounts or higher premiums than funds in out-of-favor areas of the market. For instance, the typical discount for junk-bond funds, which have struggled with the recent problems in the credit markets, pushed above 10% in October.

Trouble ahead?
Yet investors are starting to see discounts even on popular funds, such as the emerging markets. The China Fund (NYSE: CHN  ) , for instance, now trades at a discount of more than 20% despite having year-to-date asset returns of nearly 80%. The fund hasn't seen discounts this wide since 2002. Similarly, the Morgan Stanley India Investment Fund (IIF) has a 17.5% discount, even though it holds well-known stocks such as Infosys (Nasdaq: INFY  ) and HDFC Bank (NYSE: HDB  ) .

Such large discounts strongly suggest that investors think the huge gains these funds have enjoyed are unsustainable, spelling the end of a long bull market in emerging markets. But discounts also build in a margin of safety for new investors willing to take risk in volatile markets. If stocks fall but the discount narrows in response, then closed-end investors will lose less money than will investors in ETFs or traditional mutual funds.

Closer to home
Although many closed-end funds focus on the international markets, you can get bargains on U.S. stocks as well. Adams Express (NYSE: ADX  ) , for example, owns shares of well-known companies such as General Electric (NYSE: GE  ) , Wachovia (NYSE: WB  ) , and PepsiCo (NYSE: PEP  ) . Yet for every dollar of stock value, you currently have to pay only about $0.86 to buy fund shares.

Of course, just as stocks can continue falling for months or years at a time, there's no guarantee that closed-end funds will perform well. Even with discounts widening, many closed-ends have continued to give great returns to investors, so there's still plenty of room to fall if global markets have a more sustained downturn. Moreover, wide discounts won't necessarily go away anytime soon, so you won't necessarily make a fast profit.

But if you're thinking about ways to find bargains after the recent market slump, take a closer look at closed-end funds. Over the long term, it's likely that those discounts will become smaller, making your fund shares more valuable and adding some extra oomph to your returns.

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