Are closed-end funds (CEFs) that trade at persistent, double-digit discounts akin to failed consumer products? Barry Olliff of City of London Investments, a hedge fund that invests in CEFs, put forth this view during a webcast I moderated earlier this week. Also with us were Cody Bartlett of Karpus Investments and Phil Goldstein of Bulldog Investors. These three panellists are well known in the CEF industry, as they invest in CEFs and then push for corporate governance changes.
I learned a lot in the brief time I was able to spend with the panellists. All of us share the conviction that funds are meant to operate in the best interests of shareholders, even though in practice that isn't always the case. These weren't the greedy, greasy investors they are so often made out to be by CEFs trying to fight them off. Instead, they struck me as savvy, thoughtful investors who, while seeking their own profits, are looking to bring transparency to the industry, much as we at Morningstar endeavour to do. And while Cody and Phil don't mind the label of "activist shareholder", Barry does: he likes to say he isn't an activist, but he isn't stupid. Having communicated with several of our individual investors over the past year, I have a strong feeling that you appreciate Barry's comment.
Whether a board of directors has a clear-cut obligation to manage the discount is a conundrum to me. Sure, if a CEF is purchased at a deep discount, one hopes that the discount quickly narrows, that the NAV at least maintains its value, and a quick gain is made on the investment. But do directors have an obligation to ensure that the discount doesn't stray too wide for too long?
It's useful in this case to consider a company stock trading at a persistently low valuation, let's use the price-to-earnings ratio as an example. A company may produce a coveted consumer product, but for whatever reason (distrust of management, the stock's sector being out of favour, high costs, low dividend yield), the stock trades at a valuation far below that of the broader market and of its peers. In such cases, it is rare that someone puts forth a proposal to shut down the company. Typically, investors accept the lower valuation and realise that, again for whatever reason, the company will probably continue to carry a discounted valuation. If the valuation gets low enough, the company may be acquired.
Contrast this with CEFs, where a persistent deep discount (a low valuation) will likely attract institutional investors who will pressure the directors for changes that will increase the valuation. These changes may include offers of large share repurchases, liquidation of the fund, or turning the fund into an open-end fund. All of these methods are meant to narrow the discount, to increase the valuation. The arguments against such efforts are many. The discount narrowing from a one-time tender offer is usually short-lived. Liquidating the fund means that investors must find a new investment to put their money into. Open-ending a fund typically involves large risks and higher fees for investors seeking to stay in the fund. At the end of the day though, as Phil pointed out to me, CEFs aren't shrines, they are businesses. Over the next twenty years, many--perhaps most--of the CEFs currently in existence will have disappeared, replaced by new CEFs.
Should directors keep an eye on their CEF's discount and manage it appropriately? I believe so. Though they are under no obligation to do so, it strikes me as a shirking of duty to allow a CEF's share price to languish for many years at a wide discount. At the very least, they should be asking themselves why the public isn't valuing their fund at NAV. Consider again a company with an under valued stock. Quite often, when management and directors believe the low valuation to be unwarranted, the board takes action. It authorizes ongoing share repurchases, it forces management to restructure the firm's cost base, or it seeks an acquirer. It is not unusual for company directors to take action. However, when the same thing occurs to CEFs, when the share price is persistently at a wide discount, too often the directors remain silent.
Alliance Trust (ATST) is a name that has been in the headlines again recently, with activists Laxey Partners pushing for the directors to buy back shares in the market to reduce its discount to NAV. Its current discount of 17.1% is in keeping with its 1-year and 3-year averages (17.6% and 17.1%, respectively). Laxey has even set up a dedicated website to champion its cause. Laxey was also involved with Indian property company Hirco (HRCO) in 2009 and forced them to drop merger plans as well as overhaul the board. Nonetheless, the fund trades at a current discount of 93.46% and its 1-year and 3-year average discount is 86.47% and 79.4% respectively. In September 2010, we saw five directors resign from Hirco so some change at the top has happened but the figures prove it’s not an instant remedy.
I am not fully convinced that a persistently wide discount always reflects a failed fund. Good CEFs can often trade at large discounts, and still make money for investors. A large absolute discount is not always indicative of a bad fund. Investors buying into a CEF with a persistently wide discount, though, should consider how directors are safeguarding investors' best interests, in my opinion. If directors aren't willing to take the relatively easy steps needed to manage a discount, what difficult decisions are they also punting?
