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Insights: Investing

Mario J. Gabelli
From the Print Edition:
Don Johnson, Mar/Apr 02

Mutual funds come in all shapes, colors and sizes. By far the most popular today are open-end funds (both load and no-load), which offer and redeem shares at the net asset value (NAV) of the portfolio at the end of each trading day. However, the first mutual funds were closed-end funds, which issue a fixed number of shares in public offerings and trade on the exchanges just like the stocks of individual companies. While the net asset value of a closed-end fund portfolio certainly has an impact on its price, closed-end funds can trade at discounts or premiums to NAV. Put another way, dispassionate computers calculate the price at which you can buy or sell open-end funds, while the temperamental Mr. Market (supply and demand) determines the prices of closed-end funds.

Approximately 80 percent of all closed-end funds trade on the New York Stock Exchange, with market prices published daily in the stock tables. The NAVs of closed-end funds are a bit harder to track. They are published just once a week in Barron's, in Monday's Wall Street Journal, in Sunday's New York Times, and on several Web sites, including The Closed-End Fund Association (http://www.closed-endfunds.com).

A Long, Colorful and Controversial History

Before detailing the renaissance of closed-end funds and the advantages of the closed-end fund structure, let's review their long, colorful and controversial history. The first closed-end funds were British investment trusts that were formed in the 1860s. Many were created to invest in the New World, particularly to provide capital for the construction of U.S. railroads. The shares were usually leveraged with money borrowed from banks or raised through the sale of debentures. Their primary investment objective was income rather than capital gains.

During the "Roaring Twenties," closed-end funds began to proliferate in the United States. Prior to the Great Crash of 1929, closed-end fund assets totaled $4.5 billion, a significant percentage of the total capitalization of the market. While most closed-end funds were managed by responsible investment advisory firms, they were also among the favorite tools of the market shysters of the era. With the stock market roaring and common folks (best exemplified by Joe Kennedy's famous shoeshine boy) chasing instant riches, it was relatively easy for some of the shady characters of the day to sell "blind pool" closed-end funds to the gullible investing public. These funds were easily manipulated, with insiders pumping up share prices and then dumping at a tidy profit.

Due to the extensive use of leverage by legitimate managers, pyramiding (funds buying other funds), and, to a lesser degree, the aforementioned shenanigans, closed-end funds were among the biggest casualties of the Great Crash. Although the Securities Act of 1933, the Securities Exchange Act of 1934 and the Investment Company Act of 1940 reformed the closed-end fund industry with regulations designed to avoid excessive leverage and help protect shareholders from fraud, closed-end funds remained tainted and languished for decades, eventually being supplanted by open-end mutual funds.

Rising From the Ashes

The closed-end fund structure continued to be largely ignored until the mid-1980s, when a number of well-known portfolio managers, including Charles Allmon, Martin Zweig, Chuck Royce and yours truly, successfully brought new closed-end funds to market. Demand for what the financial press dubbed "celebrity funds" was strong, and other prominent investor advisers followed suit.

Due to the spectacular performance of emerging market equities in the early 1980s, closed-end "country funds" also became quite popular. Developing countries need investment capital that is patient and investment bankers correctly decided that the fixed capitalization structure of closed-end funds was much better suited to help build the backbone of emerging market economies than the open-end fund format.

The growing popularity of sector funds (portfolios of stocks in specific industry groups) in the late 1980s and 1990s also gave a boost to the closed-end fund industry. Sector fund aficionados tend to be traders rather than buy-and-hold investors, and the trading flexibility of closed-end funds suited their purposes.


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