(MONEY Magazine) – Since their last surge of popularity in the 1960s, closed-end funds have been largely ignored by investors. Recently, though, their shares have begun to attract revived interest. During the past 19 months, the number of such funds has doubled, thanks to a record-setting 47 initial public offerings, raising a total of $12 billion. In fact, the launch last June of the closed-end Nuveen Municipal Value Fund, which soaked up $1.5 billion, was the largest initial public offering in U.S. history. What makes closed-end funds suddenly so hot? Basically, both money managers and potential investors have rediscovered the advantages of these once fashionable investment companies. But you should be careful. Though underwriters promote them relentlessly because they are so lucrative, initial public offerings are usually poor values. Just like better-known open-end mutual funds, closed-end funds buy and hold portfolios of stocks and bonds. But unlike an open-end fund, which continually sells and redeems shares, a closed-end sells a fixed number of shares that trade on exchanges thereafter like regular stocks. When investors buy or redeem shares in an open-end fund, managers can be forced to buy or sell securities in the fund's portfolio, thus disrupting their orderly investment strategies. But because the number of shares in a closed-end is fixed, the managers of those funds are protected from inopportune outflows or infusions of cash. Buyers are attracted to closed-ends because most of the new funds specialize in securities or markets that have great appeal for investors. First Financial, for instance, holds the shares of small and medium-size savings and loans, a recent target group for many takeovers. So-called single- country funds concentrate on dynamic foreign stock markets, such as those in Germany and Korea. And other new funds offer the stewardship of well-known money managers such as Mario Gabelli (Gabelli Equity) or David Schafer (Schafer Value Trust), who would otherwise be available only to clients with million-dollar private accounts. Yet despite their growing popularity, closed-ends still seem a little arcane. Worse, few professionals track the funds; at last count, only half a dozen analysts were following the group closely. Even so, it is worth taking the time to figure out closed-ends because they frequently offer attractive opportunities. The fundamental difference between closed-ends and other funds is the way their prices are set. An open-end mutual fund always trades at net asset value -- the total market value of all the stocks and bonds the fund holds divided by its number of shares outstanding. But once a closed-end fund has completed a public offering, its shares trade at a price that can be above or below the fund's net asset value. Typically, when investor demand for a fund is strong, its price rises to a premium above net asset value; when demand is weak, it falls to a discount. This discount is the source of both the risks and the potential profits that the funds offer. Closed-end funds divide generally into three categories -- domestic stock funds, bond funds and single-country funds. You can purchase closed-ends just as you would any other stock. They therefore have no loads, but brokerage commissions usually run 1% to 2% when you buy and sell. The net asset values and the premiums or discounts at which major funds are trading are listed weekly in the business pages of some major newspapers, including the Wall Street Journal (Monday for equity funds and Wednesday for bond funds), and in Barron's. The first rule for investing in closed-ends is not to buy an IPO, where 7% to 8.5% of your investment is sluiced away in underwriting fees. A fund offered at $10 a share, for instance, would typically keep only $9.15 to $9.30 a share to invest in securities that make up its net asset value. Further, while funds often trade at a premium immediately after an offering because of promotion and support by the underwriter, they usually fall to a discount within six months, causing losses for investors who bought on the offering. Of the funds introduced since January 1986, those in existence for more than three months are selling at an average discount of 9%, reports Thomas J. Herzfeld, a Miami broker and investment adviser who specializes in such funds. In fact, most closed-ends trade at a discount most of the time. The size of the discount varies considerably, however, making possible a classic strategy for closed-end investing. As formulated by Herzfeld, a prime exponent of this approach, an investor would buy an equity fund when its discount widens five percentage points more than the average discount for that fund and for similar funds over the preceding six months. The investor would sell when the fund's discount narrows to five percentage points less than the usual discount. For example, consider the case of a closed-end fund that normally trades at a 15% discount. When net asset value is $10, the fund's share price would be $8.50. If the fund drops to $8 a share -- a 20% discount from its $10 net asset value -- it would be a buy. Then assume the fund's net asset value rises to $11 and the fund's discount narrows to 10%, for a price of $9.90. The investor would have a precommission gain of 24% -- from $8 to $9.90 -- even though the fund's net asset value rose only 10%. Capitalizing on changing discounts can pay off handsomely. In a recent analysis of eight different trading strategies applied to 17 closed-end equity funds, published in the Journal of Portfolio Management, Seth Copeland Anderson, a finance professor at Auburn University in Alabama, found that consistently buying funds at a 20% discount and selling them when the discount had narrowed to 15% produced compound returns of 1,380% to 3,400% over the 20 years that ended in 1985. The gain for Standard & Poor's 500-stock index was 416% for the same period. To realize the potential profits from persistently wide discounts, major investors -- including Miami broker Herzfeld himself -- sometimes buy large amounts of stock in a fund and then try to force its management to narrow or eliminate the discount by converting to open-end status or otherwise restructuring. As a result, many new funds have instituted poison pills to fend off takeovers and are also adopting more stable payout policies to reduce . discounts. The Liberty All-Star Equity Fund, for example, announced in late July that it would distribute 10% of the fund's net asset value to shareholders this year and 25 cents a share each quarter starting in 1988. Within two weeks, the fund's discount shrank from 22% to 16%. Large discounts often narrow if the stock market dips a little, acting as a cushion for closed-end share prices, says Herzfeld. But if a major market downturn develops, discounts usually widen and closed-end shareholders are hit with a double whammy -- their fund's price drops even faster than the stocks it holds. This risk is especially critical in an aging bull market. Should the averages tumble, investors who do not bail out of closed-ends quickly stand to lose more than they would in open-end mutual funds or stocks. Not all money managers agree with Herzfeld's theories. Barry Ziskin, who runs the Z-Seven Fund, believes that it makes sense to buy a closed-end without a big discount -- or even at a premium -- if the fund has a superior performance record. Ziskin argues that such a fund should be valued like any other company -- shares should trade at a high price/earnings ratio, based on the fund's annual gains. In fact, Ziskin contends that good funds should trade at a P/E of 10, even if this consistently represents a large premium over net asset value. Ziskin's own fund is selling at a 34% premium -- a P/E of 4.5 times his estimate of 1987 profits. Ziskin's argument for a P/E valuation finds little resonance within the industry, however. Norman Fosback, publisher and editor of the Mutual Fund Forecaster (3471 N. Federal Hwy., Fort Lauderdale, Fla. 33306; $100 a year), a monthly newsletter that monitors closed-end fund performance, agrees that superior management warrants a somewhat higher multiple. But he considers four times earnings the maximum a buyer should pay, given the extreme cyclicality of investment companies. The table on page 154 lists 12 closed-ends that analysts are currently recommending in three groups: Domestic equity funds. Closed-ends that invest in stock have an objective of long-term capital appreciation and lend themselves to Herzfeld's strategy because their discounts follow historical patterns. First Financial, for example, is selling at a 19% discount from its net asset value of $9.11 a share. A.G. Edwards analysts John Moran and Jeff Hopson consider this spread invitingly large, given First Financial's portfolio of northeastern and western thrifts, which are located in areas that have strong economies and stable real estate prices. Schafer Value Trust's 16.7% discount gives investors access to top-rated money manager David Schafer at bargain prices, says Steve Samuel, a partner at Drake Securities in Los Angeles, and he recommends the fund to investors seeking substantial long-term appreciation. Similarly, Liberty All-Star Fund, at a 15.8% discount, looks attractive long term to Merrill Lynch analyst Dean Eberling, ''because of its relatively low P/E stocks with average or slightly above-average yields.'' He also likes Gemini II Capital Shares, because of the fund's holdings of issues with below-average P/Es. A dual-purpose fund, Gemini II has two classes of stock: capital shares, which lay claim to all of a fund's capital appreciation, and income shares, which receive all the dividend and interest income of the portfolio. As a result of this division, though, capital shares are more volatile than the overall market. Conservative investors may prefer to buy the income shares instead, says Eberling. Bond funds. As with all fixed-income investments, the prices of closed-end bond funds move in the opposite direction from interest rates. Given the possibility that interest rates may move higher over the coming year, the ideal closed-end bond fund to buy today, according to Herzfeld, would have a relatively short average maturity (seven to 10 years), a portfolio with 60% to 70% of its bonds rated A or better, an overall expense ratio of less than 0.75%, and would trade at a 5% to 10% discount. No funds meet all these criteria right now, but several come close enough to be attractive. Excelsior Income Shares, for example, holds mostly bonds rated A or better and sells at an 8.1% discount. Excelsior's expense ratio, however, is a mite high at 0.93%. Other funds that meet most of Herzfeld's parameters are Fort Dearborn Income Securities and Vestaur Securities. First Australia Prime Income, with a yield of 11.4%, is also appealing, but Herzfeld notes that the fund is exposed to the risk of currency fluctuations. Single-country funds. Just as diversified international funds -- whether open- or closed-end -- are the simplest way to get started in foreign investing, closed-end single-country funds offer the most convenient way to ''buy'' a particular country. Choosing the right fund requires some work, though. You have to keep up with foreign economies and contend with currency % gyrations. (As a rule, a weakening of the U.S. dollar vs. the foreign currency is positive for the fund, whereas a strengthening of the dollar is negative.) Newsletter editor Fosback cautions that investors should avoid the Korea Fund and the Taiwan Fund, which sell at premiums of 150% and 127%, respectively. ''If stock prices turn down and the dollar strengthens, these markets could plunge 70% to 80%,'' he warns. The France Fund, on the other hand, currently trades at a 13.1% discount, which is greater than its historical average and is likely to narrow, says John Dessauer, editor and publisher of Dessauer's Journal of Financial Markets (P.O. Box 1718, Orleans, Mass. 02653; semimonthly, $195 a year). He also favors the First Australia Fund, which is trading at a 17.6% discount because of fears that the Australian dollar will fall, he says. The Germany Fund trades at a slight premium but is a good buy anyway, according to Dessauer, because the German market could appreciate 20% to 25% this year. Despite South Africa's problems, Fosback also likes ASA, which invests in that country's gold-mining companies. The fund sells at a 30.2% discount and will benefit if gold prices keep rising because of inflation.

CHART: Premium or discount 1987 range One-year Recent from net Premium or % gain price asset value discount to Aug. 1 Yield

Domestic equity funds Gemini II Capital Shares 16.75 -12.0 -5% to -20% +43.9 N.A. Liberty All-Star Equity $9.50 -15.8% +4% to -22% +17.3 0.9% Schafer Value Trust 8.75 -16.7 0% to -21% +24.4 0.0 First Financial 8.00 -19.0 -10% to -21% -2.0 1.6

Bond funds Fort Dearborn Income Sec. 14.75 -1.0 0% to -7% -3.9 8.2 First Australia Prime Income 8.25 -4.3 +7% to -9% +15.3 11.4 Vestaur Securities 12.75 -7.5 +1% to -15% -4.6 8.9 Excelsior Income Shares 15.75 -8.1 +5% to -12% -5.0 8.3

Foreign equity funds Germany Fund 11.75 +3.0 +15% to -9% +24.2 0.0 France Fund 12.25 -13.1 -8% to -26% +24.8 0.3 First Australia Fund 13.00 -17.6 -11% to -25% +84.2 1.9 ASA 68.75 -30.2 -19% to -52 +103.8 4.2

CREDIT: Source line: Thomas J. Herzfeld Advisors Inc. CAPTION: Closed-ends with open charms

The dozen funds below are the top picks of analysts specializing in the closed-end breed. The premium or discount is the difference between a fund's price and its net asset value (the total market value of all the securities it holds divided by its number of shares outstanding). The table also shows the percentage gain in each fund's net asset value -- including any distributed capital gains -- over the 12 months that ended Aug. 1, 1987. Exceptions: for the recently started Liberty All-Star Fund and Schafer Value Trust, nine-month results are used instead. The yield is figured -- after expenses -- on a fund's net asset value. The yield investors actually receive -- based on a fund's market price -- may be slightly different, depending on the size of the fund's discount. DESCRIPTION: See above.