Will an April selloff bring May profits for closed-end fund buyers?

Tax-related selling, coupled with a spike in interest rates, caused closed-end fund prices to dip and discounts to widen last month. As a result, CEF analysts are advising investors to scoop up closed-end funds at depressed prices before they bounce back.

"Prices of CEFs in general started to weaken in mid-April, around the time that the yield on the 10-year Treasury surpassed the psychologically important 5% level," says Mariana Bush, closed-end fund analyst at Wachovia. "A few investors may have liquidated their CEF shares to raise cash ahead of the tax deadline. Others may have taken profits on their CEF shares bought in December when valuations cheapened substantially due to heavy tax-loss selling."

CEF shares are listed on securities exchanges, are actively managed and trade intraday on the open market. They typically trade in relation to, but independent of, their underlying net asset values, or NAVs. That means that unlike open-end mutual funds, shares of CEFs can trade at premiums or discounts to their underlying NAVs. Many CEFs also use leverage, which means they will be hurt by higher borrowing costs.

During the April selloff, CEF prices weakened, but their corresponding NAVs either remained stable or sank only slightly. Consequently, Bush says, discounts to NAVs have widened to the point where they may have stretched too far.

CEFs can trade at premiums, especially when a sector gets hot or a payout gets rich, but it's discounts, and the thought of them narrowing, that tend to attract CEF buyers. CEFs will trade at discounts to their NAVs for a number of reasons, the first and foremost being simple supply and demand.

"When there are more buyers than sellers, the premium goes up. Conversely, net sellers create discounts," says closed-end specialist Thomas Herzfeld, explaining what he calls an "obvious, but often ignored fact."

Herzfeld also witnessed the selling prior to tax day and says it kept up through the end of April. According to Herzfeld, the discount widened to 4.95% on the Herzfeld Closed-End Average, an index tracking 15 diversified U.S. equity CEFs, up from 4.24% in March and 3.85% at the end of December.

Discount Shopping

CEF prices may be caught in a temporary downdraft, but Herzfeld advises investors to be selective in their shopping, because not every fund is on sale, especially those sporting overly attractive -- and often misleading -- payouts.

"The funds that have high-payout policies have become overvalued because people are chasing payouts, and in many cases, they don't understand that they are just getting their own money back," says Herzfeld.

Herzfeld is referring to funds like Cornerstone Total Return Fund ( CRF), which has a stated yield of 13.2% and is trading at a premium of 49.2%. However, almost 30% of the 17.6 cents paid out to fundholders last month was their own money back, not capital gains or earnings.

"All they are doing is eroding their asset base of the fund," says Herzfeld. "Nothing more."

Instead of chasing funds with faux payouts, Herzfeld advises CEF investors to seek out undervalued, low-payout funds trading at discounts. Such funds, says Herzfeld, have the opportunity to narrow their discounts either through management initiating discount-narrowing measures, like buying back stock, or perhaps even activist shareholders threatening to open-end them.

"CEF managers are paid an annual advisory fee based on the size of the fund, so it's in their interest to keep the fund as large as possible," says Herzfeld. "So investors should look for CEFs where the management is required to narrow the discount, or is shareholder-friendly. Choosing a fund which has shown interest by so-called 'raiders,' or activists, is a good technique as well."

Among the names Herzfeld likes are the SunAmerica Focused Alpha Growth Fund ( FGF), which currently trades at a 13.4% discount to its NAV, and SunAmerica Focused Alpha Large-Cap Fund ( FGI), which trades at a 13% discount.

Wachovia's Bush has a few CEF favorites of her own. Ten, in fact.

She arrived at her list by screening for equity CEFs where the fund's price recently declined more than its NAV, its discount is in the double digits, its valuation is the cheapest it has been in the last year and its current distribution is greater than the 5% level recently hit by the 10-year Treasury.

Bush also looked for CEFs whose NAVs have outperformed the S&P 500 and those of their peers year to date.

The names she came up with are Tortoise North American Energy ( TYN), Blackrock Global Energy & Resources Trust ( BGR), Macquarie/First Trust Global Infrastructure/Utilities Dividend & Income Fund ( MFD), Gabelli Dividend & Income Trust ( GDV) and Reaves Utility Income Trust ( UTG).

Rounding out her top 10 are Cohen & Steers Dividend Majors Fund ( DVM), Energy Income & Growth Fund ( FEN), Dreman Claymore Dividend & Income Fund ( DCS), Nicholas Applegate International & Premium Strategy Fund ( NAI) and, last but not least, like Herzfeld, the SunAmerica Focused Alpha Growth Fund.

Bush doesn't just like these funds or similar ones for a quick trade. She points out that baby boomers -- yes, them again -- are going to be looking for yield for decades to come. And that's a thirst that CEFs quench very well.

"In the next few years, we think retiring baby boomers in need of cash flow could increase the demand for the yields of CEFs, potentially narrowing their discounts," says Bush. "Few existing products provide individuals with such attractive yields."

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