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 on them, they will buy them only at a sizeable discount. And they do. Presently, the three actively traded closed end funds trade at an average discount of 28 per cent. Thus, on 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 healthy NAV performance over the past one year, the discount prevails if not widening. Trading at handsome discount ranging between 30-50 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 hazards after careful filtering.

Here are a few important factors that impact discounts and premia and possible strategies.

Performance: Funds with above average performance tend to sell at a narrow discounts or premia, where poor performance leads to deeper discounts.

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

Investor sentiments: Discount and premium fluctuate in tandem with change in sentiment, an important factor at macro level. The high premiums of 1992, when the units of the listed funds had raced ahead of the neat sset values 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 open end fund tends 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 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 payout could be another way to maximise return in a close end fund. Imagine a no-discount fund has portfolio worth of Rs 10 and can be both 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 dividend payout regularly, 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 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 around 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. Ofcourse this does require considerable fortitude. A few years ago close-end funds were the rage. Today that they are almost forgotten and likely to be extinct. They could be good buys now.

Value Research