Closed-end domestic equity funds and municipal closed-end funds enjoyed market-beating returns last year. And, while the discounts that made many closed-end funds attractive narrowed during the first quarter of this year as interest rates declined and stock prices fell, financial advisors and fund analysts say closed-end funds still present opportunities to patient investors willing to take the time to understand them.

"If a fraction of the people who understand open-ended mutual funds understood closed-end funds, we would not see these discounts," laments Mariana Bush, a Washington-based closed-end fund analyst with First Union Securities.

Closed-end funds trading at a discount offer investors an opportunity to purchase the assets in the fund cheaply and gain access to dividends. They may increase their returns if the fund holdings perform well and the discount shrinks. But all too often, those discounts get wider before they get narrower.

Last year, closed-end domestic equity funds returned 11.2% based on market price and 7.3% based on net-asset-value performance, according to the Closed-End Fund Association. By both measures, the category beat the S&P 500 Index, which declined 9.1% in 2000. Closed-end municipal bond funds gained 16.7% based on price and 15.6% based on net asset value. The category, which includes many leveraged funds, typically does well in years when interest rates are falling, says Bush, who compiled the data for the association.

In 1999, when interest rates were rising, the category was down 18% on price and 7% on net asset value, she says. The association also reported closed-end taxable income funds finished 2000 up 13% and 2.1% on price and NAV, respectively. Closed-end international equity funds reflected the performance of the broad market last year, declining 23.5% on price and 22.2% on net asset value.

Donald L. Cassidy, senior research analyst for Lipper Inc., says about 75% to 80% of all closed-end funds were trading at discounts during the first three months of this year. But the discounts were narrowing. "The closed-end universe has a clear advantage over open-end funds this year," Cassidy says. "But we've gone into a cautious phase, an income phase."

The median discount of the 476 CEFs Lipper tracks that trade on stock exchanges was 5.5% on April 27, just a fraction wider than the 5.4% year-to-date low set on January 31. The current median discount was less than half of the 11.5% recorded on December 15. The causes for the shift appear to have been more than just a December/January effect caused by investors selling late in 2000 to reduce capital-gains taxes. The present emphasis on value investing has attracted interest to CEFs, which offer bargains by trading below true asset value, Cassidy says. The April 27 and January 31 discounts were the narrowest since April 30, 1999.

Junk-bond CEFs moved from a mid-December median discount of 1.4% to a record average premium of 11.7% on March 23 before settling back to a median 5% premium at April 27. The percentage of all CEFs trading at premiums more than doubled from 10% on December 15 to more than 24% on April 27. But of those 116 funds trading at premiums, Cassidy notes, only three were not income-oriented.

Still, Cassidy and others see advantages to closed-end funds. Investors can gain access to venture-capital funds and some very small emerging markets not covered by open-ended funds. And closed-end fund managers are not pressured the way mutual fund managers are to buy high and sell low by inflows and outflows of cash as markets take off or tank.

First Union's Bush says advisors need to look at the credit quality of income funds and to have a feel for how much risk they are taking. "Check on whether the fund dividend is going to be stable," she suggests. "It's not easy to find that information. The funds are not going to tell you." With a municipal-bond closed-end fund, advisors should be aware of the fund's call exposure. If it has significant call risk over the next year or two, its dividends are going to be cut. "If it has a lot of call risk, it's going to be more sensitive to interest-rate changes," she says.

Thomas J. Herzfeld, president of the Kendall, Fla., company that bears his name and the creator of the Herzfeld Closed-End Fund Index, typically examines 20 to 25 variables in evaluating closed-end funds. "The strongest weighting is the discount to NAV. The other things we look at include expense-ratio performance, tax liability, liquidity of shares and portfolio and what the fund's strategic positions are," says Herzfeld, who has been following closed-end funds for 33 years.

While he says closed-end funds make sense for all of the reasons mutual funds do, he cautions that advisors have to be able to determine whether the discounts or premiums are likely to contract or widen. "Our strategy is to rotate money into closed-end funds with higher discounts. We look for closed-end funds with discounts that are higher than the Herzfeld index average. We hold the majority of our positions for three to six months. It simply leaves too much on the table to buy and hold."

Herzfeld recommends this simple method for evaluating the likelihood of whether a discount or premium will narrow or widen: Only buy a fund if its discount is 5% wider than its average over the past six months and currently is wider than similar funds.

Lewis J. Altfest, president of L.J. Altfest & Co., in New York, likes closed-end funds because he can take advantage of the discounts to earn an extra return. Just before Christmas, he took a position in a Duff & Phelps municipal bond CEF that was trading at a discount to NAV of about 20%, a much bigger discount than it historically had experienced, with a yield of 6.25%, when other municipal bonds were yielding about 5%. "In municipals, an extra 1% is a home run," Altfest says. "I saw this as a capital-gains play as well. It had a respectable expense ratio. From January 1, the discount started to come down. It's now 10%. That's a 10% capital gain. In muniland, that's two years worth of gains, and if it continues to narrow, we'll sell it out. It wasn't the December/January effect. It was the fund itself."

Cassidy says bond fund investors tend to be better suited for closed-end funds than equity investors. "With equities, you're really overlaying all of the uncertainties of a given market on top of the uncertainties of what will happen to the fund discount or premium. Equity closed-end funds tend to feed on people's fear and greed a little more than the average fund," he says. "Clearly, in 2001, you don't want to own higher-yield funds." Still, with equity funds that are sold on a yield basis, like REITs, closed-end fund managers feel less pressure than mutual fund managers to increase risk by reaching for that extra yield that will draw new investors to their open-end funds.

Closed-end funds are most attractive when the asset class or sectors they hold are out of favor, says Joel P. Bruckenstein, a CFP with Pembroke Pines, Fla.-based Global Financial Advisors Inc.

"If you're looking to be a contrarian, it's a good idea to see what's out there in the CEF universe before buying a mutual fund," Bruckenstein says. "Closed-end funds also are appropriate when you want to buy into a country that has no easy alternative for purchase. Finally, now may be a time to look at the venture-capital closed-end funds. The portfolios are down. Everybody hates them, and they are selling at a big discount."

Bruckenstein says he never buys closed-end funds at the initial offering. "Inevitably, they come out with new funds when a sector is hot," he says. "You never want to buy at an IPO because you're going to be paying a premium."

Paul S. Baumbach, a CFA with Mallard Asset Management Corp., of Newark, Del., believes closed-end funds are best suited for patient investors. "You have to be willing to hang on for several years in case the discount stays wide," Baumbach says. "You can't buy them assuming you're going to be able to get out quickly. You have no control over that period of time."

This explains why Baumbach likes to use closed-end funds in tax-sheltered accounts. "So, when the discount narrows, you don't have to pay taxes for the privilege of selling to improve your portfolio. Also, this enables you to be indifferent to levels of portfolio turnover and capital-gain overhang within the CEF."

Baumbach's taste recently has turned to small-cap value closed-end funds, and he has used a Royce small-cap value CEF. "They don't go after that technology boom," he says. "They are tire kickers and they go after that small cap value."

As the markets were hitting yearlong lows in mid March, Altfest says he was examining both domestic and foreign closed-end funds for potential bargains. He was tracking the performance of funds whose managers had been in place for at least three to five years relative to their peers over those time periods.

"The way the market has been acting, individuals will be liquidating aggressive domestic and international funds, and discounts are likely to widen," he says. "If they widen sufficiently, I may be a buyer."