Speculators Benefit From Shift In Closed-end Funds

by Philip Morton, Investorsoffshore.com

07 June 2001

Some long term investors and arbitrageurs have profited substantially from last year's flight from the riskier asset classes, according to experts. Because they trade on exchanges, closed-end funds have a second price besides their Net Asset Value (NAV)- the price at which people actually buy and sell the shares. Although closed-end fund investors are accustomed to their funds trading at a discount to the NAV of the securities in the portfolio, the 2000 exodus from the riskier asset classes caused an unusual shift in the world of international closed-end funds by widening the discount to NAV in many funds investing overseas considerably.

Arbitrageurs and speculators saw the opportunity, and many bought big holdings in deep discounted funds. Having gained a majority stake, they then proceeded to put pressure on the funds to take action to narrow the discount. Some forced the fund company to change the fund into an open-ended mutual fund (which must be priced at the full value of the assets in the portfolio), or to liquidate. When an open-end fund is liquidated, companies must pay shareholders close to the full value of the securities in the portfolio, which meant fast bucks for those investors large enough and daring enough to speculate.

In response to this, closed-end fund groups were forced to boost their flagging fund prices by either holding tender offers (offering to pay investors directly for their shares, often at the NAV price), buying shares in their own funds on the open markets, or consolidating small funds to make them more liquid, and less vulnerable.

Simon Kelly, an analyst at JP Morgan's closed-end fund research department summed up the mood at the time, and the aftereffects of the international shift: 'There was a lot of screaming from shareholders and the emerging markets were falling out of bed. That increased corporate action to increase shareholder value. We have since seen a contraction in the size of the market and a narrowing of discounts over the last six months.'

Although arbitrageurs and large investors have done very nicely out of the situation over the last year, experts feel that few individual investors can make money consistently in this way, as it is just too difficult to predict which funds will open-end, and even if you guess right, particularly with funds that invest in volatile areas such as emerging markets, there is a chance that the fund's price could decline so much in the period before open-ending that the potential gain would be wiped out.

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