UNDERSTANDING CLOSED-END FUNDS:
Discounts, Activists and Open-Ending
By the Closed-End Fund Association
Closed-end funds offer investors a unique combination of benefits including professional money management, diversification, exchange-trading, and the ability to use leverage, among others. While they are similar to mutual funds, because closed-end funds trade on a stock exchange and have a stock price that is set by market forces that can differ from the fund’s net asset value (“NAV”), closed-end funds can sell at premiums and discounts to their NAV. Why do discounts exist in the first place? Numerous academic studies have looked into the question and none have identified a satisfactory reason. Discounts appear to be primarily the result of investor sentiment and supply and demand forces. Something the studies generally agree on is that discounts are not a reflection of the fund manager’s capabilities or the result of investment performance by the fund.
The fact that closed-end funds typically trade at a discount can draw the attention of a class of investors with a short-term outlook, known as “activists.” These investors scour the closed-end universe for funds which may have been trading at a discount for a prolonged period of time, buy them at the discount, and, in a very small number of situations, they attempt to “open-end” the closed-end fund or to have the fund liquidated. “Open-ending” refers to converting the charter of the fund from a “closed-end fund” which trades at market prices, to a traditional “open-end” mutual fund which is required by law to trade at NAV but can only be bought and sold at end-of-day prices. Activist arbitrageurs often argue that their efforts to attempt to open-end a fund helps investors in the fund by narrowing persistent discounts. In fact, studies have shown that such actions only temporarily narrow discounts. The reason is simple — when investment markets learn that such actions are imminent, professional buyers begin to take positions in the fund in question in order to arbitrage the market inefficiencies that exist, and their buying activity has the effect of narrowing the discount.
Studies also show that the effect is temporary and usually to the primary benefit of the activists and professional arbitragers. If the activists do succeed at forcing a fund to open-end, the discount will disappear (albeit from the narrower level caused by the open-ending effort). But so will the many benefits provided by the closed-end fund structure that attracted the long-term investors to the fund in the first place. In that event, long-term closed-end fund shareholders of the fund are faced with a decision to either sell their shares in order to take advantage of temporarily lower discounts or risk being placed in a traditional mutual fund — and face, among other things, unwanted tax consequences from the fund’s selling shares to cash out departing investors and a substantially higher expense ratio from the process. And a fund that is not able to convert into a mutual fund for a variety of reasons would be forced to liquidate and go out of business.
For these reasons, we believe that shareholders of closed-end funds should be very cautious about any action taken or perceived by a shareholder activist against a fund manager to open-end a closed-end fund, and should proceed with caution as there are many sides to the issue and many factors to take into consideration.
