But this is unlike getting a designer suit in a clearance sale at 30 per cent discount on the retail list price. After all, you may well face the same discount when you want to sell the fund. But, other things being equal - like performance, expense ratios and yields - a deeply discounted closed-end fund is likely to be a better buy than a comparable open-end fund. Imagine that the UTI's open-end fund, Mastergain, has a portfolio worth Rs 100 a share and can be bought at Rs 100 while sold at a marginally less than Rs 100 a share. The UTI's closed-end fund, Mastershare or the Mastergrowth, has an identical portfolio worth Rs 100 a share, but its shares trade at Rs 70. Let's say both net asset values double to Rs 200. And assuming the closed-end funds' discount stays stubbornly at 20 per cent, so when you go to sell, the shares are trading at only 160.

Apart from brokerage commissions, your capital gain is the same: In either fund you double your money. But wait. What if the portfolio throws off Rs 20 dividend after expenses? That's a 20 per cent return on your investment in Mastergain, but a 29 per cent return at Mastershare. This yield effect boosts your total return on the closed-end fund.

How is it that a fund could have a Rs 100 net asset value but trade at 80? It's very simple. Open-end mutual funds will buy your shares back on demand at net asset value. Closed-end funds won't, and you can sell them only for what other investors are willing to pay. If other investors are lukewarm on them, they will buy them only at a sizeable discount. Like now. Despite similar portfolio results, discounts have been widening.

Factors influencing discounts/premiums

Many funds consistently trade at, close to, or around, a particular level of discount or premium. There may be many factors responsible for determining whether a fund will trade at a premium or discount, and how much the premium or discount will be. Changes to these factors may cause the discount or premium to adjust to a new stable level.

Ignorance

Perhaps, the most important factor why most closed-end funds trade at a discount is that now they operate in relative obscurity, and hence demand for their shares is low.

While most investors hear so much about mutual funds, very few have heard about closed-end funds. And for obvious reason, funds advertise extensively to attract investment money, since the management is paid a percentage of the assets managed. However, closed-end funds except under very rare circumstances, operate with a stable pool of investment money. Advertising will not increase the asset base and instead, the cost of advertising erodes the assets of the fund.

Performance

A closed-end fund that consistently under-performs the indices relevant to the fund will eventually trade at a discount as investors leave the fund and fewer investors buy into the fund. And conversely, a closed-end that consistently outperforms the indices and related funds will trade at a premium. However, in recent years, hardly any fund has traded at a premium with the exception of guaranteed return funds.

General market sentiment

The market sentiment plays a significant role in the premium /discount of closed-end funds. When investors are particularly bullish, as was the case in 1992 and 1994 many funds traded at sharp premiums, many in excess of 30 per cent premiums. Similarly, when investors are particularly bearish, as was during 1995 and 1998, many of the same funds traded at wide discounts, often in excess of 20 per cent.

Excess supply

The introduction of new funds investing in the same markets tends to increase discounts since these new funds draw away money that would otherwise have been committed to the older funds. For example, the introduction of Mastergain led to a sharp drop in the premium of Mastershare in 1992 and Magnum Multiplier Plus in 1993 led large discounts on the new fund besides the older fund, Magnum Multiplier 90.

Conversion into open-ended

Funds that trade at excessive discounts and/or have an attractive portfolio may be under pressure to convert into open-end. So investors can buy large block and thereby profit from the disappearance of the discount. Depending on time for conversion into open-end, the discount may shrink or disappear. Watch the narrowing discount on Mastergrowth.

What a difference a few years make. During 1992 and 1994, mutual funds foisted Rs 7000 crore of new closed-end equity funds on investors. Investors happily paid brokers 7 per cent commissions - that is, they paid a bit more than Rs 1.07 for a rupees worth of assets. By the end of 1993, the UTI's Masterplus and SBI's Magnum Multiplier sported 100 per cent and 150 per cent premiums, respectively. Now the UTI's Masterplus languish at a discount of 30 per cent, while SBI's Magnum Multiplier had to be converted into an open-end fund.

To succeed at this game, you've got to buy when everyone is selling. Now is a great time to buy. In choosing a closed-end fund, don't just look at past performance. Keep a close eye on discounts and quality of portfolio. As a rule of thumb, don't buy a fund unless it outperforms the relevant benchmark over the past three years.

The funds available on discount are rare species and will soon be extinct. These funds combine good discounts with performance ahead of a relevant benchmark over the past three years. Buy and hold, before you cannot.

-- Dhirendra Kumar, Value Research