Tuesday, April 5, 2011

Timing Closed-End Funds

Closed-end funds can and do trade at significant differences to their net asset values. But do these situations offer value investors strong upside potential while employing minimal risk? It depends on the situation. For example, consider shares of Canadian World Fund (CWF), which trades at a 30% discount to the market value of its net assets.

There can be many reasons for a fund to trade at such a large discount to its net assets, some of them quite reasonable. Often, some of the companies or securities in which a fund has invested are not even listed on public exchanges. This reduces the level of confidence an investor can have in the actual value of the net assets. In CWF's case, 99% of the fund's investment portfolio is public. Investors in CWF with access to global stock markets could theoretically short these stocks to reduce their risk.

But owning shares of a fund is not the same thing as owning the shares of each individual company, and not just because of voting rights. Investors in the fund have to fork over a management fee for the right to hold those stocks. While the fee might seem trivial in relation to the discount (e.g. the fee might be in the range of 2%), the fee is annual, and therefore a better comparison of the fee to the discount involves calculating the fee's present value for a number of years out, and subtracting it from the fund's net asset value. In many cases, this exercise can reduce even a seemingly large discount to zero! CWF has a management expense ratio of around 2.5%, which will significantly eat into shareholder returns over a number of years.

Another item worthy of discussion for investors considering closed-end funds trading at large discounts is management's incentive structure. Does management want to grow the company and thereby grow in importance and salary, or does management want to maximize shareholder value? The answer to this question can go a long way in determining how a fund is likely to react in the face of a large discount. In the case of CWF, it is controlled by the same people who own the management company. As such, they are likely to want to grow the fund (and increase fees) rather than shrink through a buyback, even though shareholders would benefit greatly from the latter.

Of course, management's abilities are also important. A closed-end fund run by Warren Buffett, for example, would probably trade at a premium to its net assets, under the assumption that net assets would grow at a faster rate than the market. In CWF's case, however, the fund has seen its net asset value grow by 0.2% annually over the last ten years...before fees! The fund's prospectus notes that past performance does not necessarily indicate future performance; for the sake of CWF's shareholders, I hope it doesn't!

Finally, as strange as this may sound to bottom-up value investors, they may want to consider the level of the stock market as part of their analysis of a closed-end fund. Is the market priced for perfection (e.g. by using a long-term valuation tool such as the PE 10) ? This may give the investor an indication as to whether the company's net assets are likely to rise or fall in the coming years.

CWF does trade at a large discount to its publicly traded net assets. However, when considering management's fees and incentives, the discount no longer seems so grand. Furthermore, considering the market's PE 10 levels (which are approaching the mid-20s) along with CWF management's poor performance track record, CWF's net assets may be likely to fall over the long-term, which may reduce or eliminate any remaining discount in the eyes of value investors.

Disclosure: No Position


Paul said...


This may sound incredibly stupid, but when you said "the fee is annual, and therefore a better comparison of the fee to the discount involves calculating the fee's present value for a number of years out, and subtracting it from the fund's net asset value."

how do you go about calculating that? Do you discount it by the risk free rate or what?

Saj Karsan said...

Hi Paul,

Yes you could do that; you could also use your cost of capital. The point is that the fee is a real cost that you may wish to quantify.

Paul said...

that makes, sense. thanks for the insight, as always! :)