Lipper Senior Research Analyst Don Cassidy on KTLK AM-760
Thursday, September 11, 2003
Q. Don, it seems that Wall Street is almost always setting some new recordof some sort -- what do you have to talk with us about this week?A. Closed-end fund issuance. We are only a little over 2/3 of the wayinto the year, and a new IPO dollar record has been set for any FULL year!
Q. OK, tell us about that, but then we probably also need to talk aboutWHAT a closed-end fund is.
A. You're right about that. They represent less than 3% of totalfund-industry assets and are not exactly a household word. And they areactually older in origin than the familiar mutual fund, which dates back toonly 1924 in this country.
So far in 2003, there have been 30 closed-end funds conductinginitial public offerings (IPOs), and they have put a total of $19 billionof new assets under management. This is up from $15.7 billion in all of2002, raised for 77 new funds. And it tops the old record of $18.5 billionby 121 funds back in 1993.
Q. How does the amount raised this year compare to total assets inclosed-end funds.
A. It is virtually 12%, since total assets in closed-end funds now areabout $160 billion. Another record for 2003 so far has been the averageSIZE of new funds: it is over $600 million per offering! Last year it wasabout $250 million per fund, and the industry average is about $280 millionper fund.
Q. OK, let's back up and explain what closed-end funds actually are andhow they differ from mutual funds.
A. Sure. A closed-end fund is an investment company very much LIKE amutual fund, with one major difference: the closed-end fund does NOT standready to redeem its shares for cash from owners every day the NYSE is openfor business. Closed-end funds ARE actively managed portfolios, just likemutual funds, and MOST (about 95%) trade on a stock exchange or on NASDAQ.They have all the same regulatory reporting requirements of a mutual fundunder SEC rules.
Q. So if these closed-end funds do not redeem their shares, how does aninvestor get out if they want to?
A. With the ones trading on an exchange, just as you would sell yourshares in GM or GE or Xcel Energy: you sell the stock through a broker, onthe stock exchange, to someone who wants to buy. That of course means thatsupply and demand determine the price, which might not be exactly equal tothe underlying asset value per share (NAV). With the funds that do notlist and trade, they offer to buy back shares periodically, either monthlyor usually quarterly. So people can get out then.
Q. Why would a management company create a closed-end fund rather than anopen-end, mutual fund?
A. Three main reasons: asset-class match, raising permanent capital thatdoes not go away, and the chance to use leverage.
Q. Better explain...
A. Some investable asset classes are very illiquid, like stocks inmicro-cap companies or in very small overseas stock markets, or evenmunicipal bonds. These are great matches for the closed-end fund format,since the portfolio manager does not need to worry about being able to meetredemption demands. Leverage IS technically available in open-end fundsbut is almost never used for technical reasons. But closed-end funds donot need to worry about redemptions and that makes using leverage anattractive option, especially for income funds. The management companiesnearly always collect fee on the extra assets, too.
Q. OK, so WHY have there been record new issues of closed-end funds thisyear, when investors are still skittish after the bear market?
A. This has been an income-oriented market, and interest rates are low,and closed-end funds can pay higher yields because of their use ofleverage.
Q. So are we mainly talking about BOND funds that have come out lately?
A. Actually only 14 of this year's (so-far) 30 IPOs have been for debtfunds. But all except one of the rest have been for income-oriented fundsor mixed-equity funds with a significant income flavor.
6 High-Yield Bond funds
4 Municipal-Bond funds
1 General bond fund (medium quality)
1 World-Income bond fund
2 Loan Participation funds
1 growth-type equity fund
6 Convertible Securities funds
6 Preferred Stock funds
2 REIT funds
1 Balanced fund
Q. Definitely a strong income "flavor" there.
A. Right. And with the ability to use leverage, these funds can providehigher yield than an open-end fund not using leverage would do.
Q. How does that work?
A. The fund borrows money at a low interest rate, on a short-term rollingbasis. It re-invests the extra money it borrows -- at higher rates bybuying longer-term securities paying higher rates -- bonds, preferredstocks, REITs, or convertible bonds for example.
Q. It sounds like borrowing on margin from your broker at maybe 5% andbuying a bond or an REIT with a higher return. Isn't that almost ano-brainer?
A. If the security does not default AND ITS PRICE DOES NOT DROP, it wouldbe like free money. But if interest rates rise those bonds and preferredswill fall and you may get the high yield but your principal will declinefaster than if you were not using the leverage. Just as in a personalmargin account.
Q. Do you think all those investors who have bought these new funds areaware of that risk?
A. We are concerned about that, because we know people often hear the"return" or "yield" part of the story but do not listen for the "risk"side. We at Lipper recently (August 18) published a report about that,which is available free on the web at www.Lipperweb.com
http://www.lipperweb.com/usa/products/studies.shtml#LeverageQ. So, do you think these leveraged income funds will prove a mistake forinvestors?
A. Not if they either can-and-DO hold forever, OR if they are willing tostep aside by selling if interest rates start to rise for real. In the longterm, investors WILL get a higher CASH yield from them, but their TOTALreturns will be volatile as interest rates change. The funds themselvesare neither good nor bad -- it's how the investor interacts with them thatdrives results. We just hope people understand what they own! True withALL investments, fund or otherwise.
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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