When The Lid Comes Off Closed End FundsToddi Gutner
Closed-end funds have become a target for savvy investors turned activist shareholders. They're aiming to capture a windfall by forcing closed-end funds, which trade like ordinary common stock, to transform themselves into traditional open-ended mutual funds. These closed-enders usually sell at a big discount to net asset value (NAV) of their portfolio largely because they have performed badly. When such a fund opens, shareholders can cash in because they can redeem their shares at full asset value. When Pilgrim America Bank & Thrift Fund remarked that it might open, the share price jumped nearly 9% in three days, as the discount between the fund's market value and NAV shrank from 12% to 4%.
Open-ending is on the rise. Four funds have converted so far this year, and votes are scheduled for seven more by yearend. One is scheduled to open in October and one in early 1998, according to Thomas Herzfeld, a veteran closed-end fund trader in Miami and publisher of the 1998 Encyclopedia of Closed-End Funds. That's up from four last year. "The trend has been under way in offshore funds for several years and is now gaining momentum in the U.S.," says Michael Porter, the closed-end fund analyst at Smith Barney. That's partly because of increasing pressure from activist institutions and the Securities & Exchange Commission forcing fund managements to adhere to prospectus provisions to narrow persistent discounts.
Closed-end funds are not hard to find. About 460 are listed on the New York Stock Exchange alone. And of the 487 closed-end funds, 365 trade below NAV, according to Lipper Analytical Services. The average closed-end discount is 9.23%, down from 10.04% in 1996. But some run as high as 30%. Because the share price is determined by investor interest, funds that are performing poorly and have few prospects generally sell at deep discounts.
POOR PERFORMER. It's tough to predict which closed-end funds will be forced open or targeted for other discount-narrowing techniques such as share buybacks or tender offers. But three factors make a fund a good bet for changing its stripes. For one thing, the fund should be selling at a hefty discount to NAV, say 15% or more. Second, institutions should own a good slice of the outstanding shares. And last, the fund's prospectus should contain provisions for narrowing or eliminating discounts. According to a recent Herzfeld study, 88% of the closed-end funds have such provisions.
Those funds that trade with a chronically wide discount are worth a look. Take Latin America Growth Fund, which has been plagued by a double-digit discount for over a year and traded at nearly 21% below its NAV on Sept. 15. The fund has had an NAV return of 18.5% for the first six months of this year. Rival Latin funds gained 21% to 45% in the same period.
Steep discounts often attract institutional investors hunting for bargains. Porter estimates that institutional ownership of closed-end fund shares has jumped from single digits to the high teens since the end of 1995. Any closed-end fund with an institutional ownership of 20% or more is worth considering because the institutions might mobilize other shareholders to take action to change the fund's structure.
Some institutions are more aggressive than others. A few groups are known for their activism: Newgate Management Associates, based in Greenwich, Conn., Harvard College, City of London Investment Management, Lazard Freres & Co., and Phillip Goldstein, who runs Opportunity Partners, a $40 million hedge fund that specializes in closed-end funds in Pleasantville, N.Y. Their stake in a closed-end fund does not guarantee an open-ending, but the odds are higher.
Many of these players have positions in Latin America Growth. Institutions own 46%--City of London Investment Management, Harvard College, and Lazard Freres among them, according to CDA/Spectrum, a stock ownership research firm in Rockville, Md. Scudder Spain & Portugal Fund, formerly called the First Iberian Fund, is also a good open-end target, says Goldstein. The fund faces a shareholder vote for approval of a new adviser on Oct. 21, and activist shareholder City of London Investment Management owns 17% of the total 22% of institutional holdings. What's more, the fund has languished with a persistent 16% discount.
While Latin America Growth and Scudder Spain & Portugal have provisions in their prospectuses to narrow discounts, there are no votes scheduled to open the funds. Of course, the less certain the outcome, the steeper the discounts and the greater the potential return for adventurous investors.
Another way to play the game is to buy funds that have scheduled shareholder votes to open the fund. There is usually a lag between the announcement for open-ending and the final action. Discounts persist throughout the process. Schroder Asian Growth Fund, selling at a 10.5% discount, was scheduled for an open-ending vote in mid-September. Pilgrim America Bank & Thrift and GT Global Developing Markets Fund have votes coming up in mid-to-late October. Pilgrim's discount is 5%, and GT's is 8%. City of London Investment Management, Lazard Freres, and Harvard College are among the institutions that own 29% of GT.
SIPHONING OUT. While closed-end watchers speculate that these three funds will open, there's still a chance they won't. When open-ending votes come up, apathetic investors frequently just check off management recommendations or don't cast ballots. Funds often require approval of 67% to 80% of the outstanding shares for an open-ending proposal to pass. What's more, management usually opposes opening a fund because fees are based on assets, and once a fund opens, money siphons out. Rather than going for the open-end option, management may choose to buy back or tender shares.
The least risky strategy is to buy a fund that has announced it will open. Two funds are in that position. Alliance Global Environment will open on Oct. 2 and still trades at a 3% discount. And TCW/DW Emerging Markets Opportunities Trust trades at an 8% discount despite its scheduled conversion early next year. "The discount has narrowed [from 13%], but it is still a good buy," says Porter. Risk remains, however. The return gained on the spread between the discount and the NAV can be wiped out if the fund performance plummets between the time of the vote and the action to open.
Controversy surrounds two other closed-end funds: Templeton Dragon Fund (which invests mainly in China and Japan) and Templeton Vietnam Opportunities. On Sept. 23, Templeton Dragon shareholders were scheduled to vote on whether to restructure the fund into an interval fund. Such a fund differs from the closed-end structure in that management allows for periodic redemptions at NAV of a predesignated number of shares. Whether the proposal will be approved is anybody's guess. When management opposes the change, as they do in this case, it's almost impossible to get the proposal passed, says Herzfeld. Goldstein, however, argues that with the fund selling at a 22.5% discount to NAV, "shareholders may make a good showing and force management to do something." Indeed, 19% is owned by institutions, including heavy hitters Newgate Management and City of London Investment Management.
Templeton Vietnam Opportunities is an unusual case. The prospectus mandates that 65% of the fund's assets be invested in Vietnam by its third anniversary this fall. It hasn't met that requirement. Only about 15% of the portfolio is invested there. At the Oct. 1 board meeting, management will assess the portfolio and recommend whether the fund should be liquidated, open-ended, or modified into a regional closed-end fund. A shareholder vote will be scheduled. "I think they will convert to an open-end regional fund to comply with the prospectus," says Porter, citing the 11% discount to NAV and the 23% decline in the stock price since the fund's initial public offering. Franklin Templeton Group, the fund family, declined to comment on the status of either fund.
Even if none of these closed-end funds open, you can still make money over the long term if the underlying portfolio appreciates or the discount narrows. It's probably as close to a win-win situation as you're likely to get in these turbulent markets.