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Closed-end Bargains

Dhirendra Kumar

Why buy a close-end fund stock when an open-end fund offers the convenience of easy liquidity, dividend reinvestment, and systematic investment and withdrawal plans?

Unlike an open-end mutual fund which issue and redeem shares continuously, a close-end mutual fund stock has a fixed number of units outstanding (unless units are being repurchased). While most of the open-end funds units can be bought and sold at very near their underlining value (NAV), close-end funds trade not on their net asset value but on what other investors are willing to pay for their shares.

If other investors are lukewarm to them, they will be bought only at a sizable discount. And that's what is happening. Presently the three actively traded closed-end funds trade at an average discount of 28 per cent. Thus on an average a lot of close-end funds, holding many of the same securities as the open-end funds, trade at average price of Rs 7.20 on a Rs 10 net asset value. Despite a healthy NAV performance over the past year the discount prevails if not widening.

Trading at a handsome discount ranging between 30 to 50 per cent, they are just too good to be true. So don't rush to your broker with a buy order on the fattest discount to the NAV. While some of these could well turn out to be rare gems, one has to steer clear of many a hazard. Here are a few important factors that impact discount, premiums and possible strategies.

Performance: Funds with above average performance tend to sell at narrow discounts or premiums; poor performances lead to deeper discounts.

Liquidity: Small illiquid funds may trade at deeper discounts or high premium. A large discount or premium can quickly vanish when you place an order to buy or sell a relatively illiquid fund so it may not be a big bargain after all. Zurich India Quantum and UTI's Index Equity Fund are a good illustration.

Investor Sentiments: Discount and premium fluctuate in tandem with change in sentiment, an important factor at macro level. The high premia of 1992 and the hefty discounts of 1996 amply reflect this.

Turnarounds like Morgan Stanley and Mastergrowth could provide good opportunities. The price gain in Morgan Stanley is entirely driven by its performance and the fund's initiative to change perception with its communication and an interim dividend. Post-restructuring, the fund seems to have turned the corner. Over the past six months the fund has appreciated by around 30 per cent. Despite the strong performance the discount prevails.

Special Events: Approaching redemption, repurchase, conversion to an open-end fund -- all these tend to narrow the discount. The approaching redemption of Mastergrowth has resulted in a reduction of discount from over 41 per cent a year ago to 12 per cent today, while Mastershare with its redemption in 2003 trades at a 32 per cent discount.

Despite the narrowing of the discount Mastergrowth should still yield a handsome 13 per cent return for the holding period of few months with a possible upside, given the strength of PSU stocks and limited downside risk.

Dividend: A possible dividend payout can also narrow the discounts. Besides finding bargains, dividend payouts could be another way to maximise return in a close-end fund. Imagine a no-discount fund has a portfolio worth of Rs 10 and can be bought or sold for Rs 10. Another fund has an identical portfolio of Rs 10 but is available at Rs 7.75.

Let us say both double their NAV to Rs 20 and also make a pay-out of 20 per cent. The discount in the latter stays at 22.5; so when you go to sell the stock is trading at Rs 15.50. Though the capital gains is same the yields are different and your return in the former works out to 120 per cent while it is 125.81 per cent in the latter. With Mastershare making a habit out of dividend payout, this strategy could be applied to boost your total return.

Discounts can also be used to bring down your average cost of acquisition. If you have been one of the original investors in the Morgan Stanley Growth Fund and are convinced of its future prospects the fund is available at an attractive 38 per cent discount. At the current market price of Rs 11 you could bring down the average cost of your holding by buying more Morgan Stanley stocks and maximise you over-all return in the future. Of course, this does require considerable fortitude.

A few years ago close-end funds were the rage. Today they are almost forgotten and likely to be extinct. But they could be good buys now.

Mutual Funds

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