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Stay Away from This Emerging-Markets Play

Buying closed-end funds at huge premiums can lead to nasty surprises.

Gregg Wolper, 10/10/2006

When you buy an emerging-markets fund, you take on extra risk. Although there are plenty of stable, solid companies available in emerging markets, and the governments of many such countries have improved their financial management over their years, the currencies of those countries are still more vulnerable to swings, and they harbor a greater amount of political risk. For example, government instability or sharp policy shifts can play havoc with currencies and stock markets alike.

True, the recent coup in Thailand and the current political turmoil in Mexico have not led to plunging markets or currencies in those countries. At least, not so far. But those events do serve as timely reminders of the risks found in emerging markets that you don't find in, say, Switzerland.

With that in mind, adding even more risk to the equation is a questionable move to make. But some people do just that. Instead of buying a broadly diversified emerging-markets fund--one that can invest all over the developing world--they'll buy one that invests in just one region or one country. If trouble hits that region or country, such funds can't shift their assets to more stable areas.

What may surprise you is that there's yet another layer of risk one can add: buying an emerging-markets closed-end fund at a huge premium. The problem there is that you can get the story right and still lose out. In other words, even if the fund's holdings rally as shareholders hope, that extra risk factor--the premium peril--can sabotage shareholder returns.

When the stunning growth rates of specific countries or regions become the fodder of magazine cover stories and TV profiles, you might be tempted to try to cash in by jumping into such a fund even at a steep premium. Resist the temptation.

Enter the Dragon
When you're buying a conventional mutual fund, you buy it at its net asset value, or NAV. (A sales charge may be added for a broker-sold fund.) A closed-end fund is structured differently; after raising its initial asset base, it closes. Shares can then be bought only from existing shareholders on an exchange, as with a stock. As a result, its price is almost always higher or lower than its NAV--meaning it's selling at a premium or a discount, respectively.

The problem with buying at a premium is that the premium can contract--a 20% premium can become a 10% premium, or even slide to a discount--even as the fund's underlying holdings, and thus its NAV, are rocketing ahead. And then you, the shareholder, won't get the full amount of that NAV gain. In the worst case, you won't get any gain at all, despite a rally in the stock market you've targeted. The problem can occur even when a fund sells at a modest premium, which could turn into a discount, or sells at a small discount, which could fall to a deeper discount. But the risk is enhanced when you initially buy at a hefty premium that, history shows, is unlikely to be sustained.

This isn't just theory. The process has hurt actual shareholders in recent years. Perhaps the most notable example is China Fund CHN. In 2004, even though China-related stocks didn't perform nearly as well as those in other emerging markets, the securities in this fund's portfolio did eke out a 1% gain. But that was in NAV terms. On a market-price basis--what shareholders actually received--the fund suffered a painful 11% loss. That's because the premium contracted as the fund's shares traded at lower prices. The next year things improved in NAV terms--but became much worse for shareholders. The fund's NAV return in 2005 was 5%, but, remarkably, shareholders got stuck with a 22% loss, as the premium kept shrinking.

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