Investment companies begin like any other company—someone sells an issue of common stock to a group of investors. An investment company, however, uses the proceeds to purchase the securities of other publicly held companies rather than buildings and equipment. An open-end investment company (often referred to as a mutual fund) differs from a closed-end investment company (typically referred to as a closed-end fund ) in the way each operates after the initial public offering.
A closed-end investment companyoperates like any other public firm. Its stock trades on the regular secondary market, and the market price of its shares is determined by supply and demand. The typical closed-end investment company offers no further shares and does not repur- chase the shares on demand. Thus, if you want to buy or sell shares in a closed-end fund, you must make transactions in the public secondary market. The shares of many of these funds are listed on the NYSE. No new investment dollars are available for the investment company unless it makes another public sale of securities. Similarly, no funds can be withdrawn unless the invest- ment company decides to repurchase its stock, which is quite unusual.
The closed-end investment company’s NAV is computed twice daily based on prevailing mar- ket prices for the portfolio securities. The market price of the investment company shares is determined by the relative supply and demand for the investment company stock in the public secondary market. When buying or selling shares of a closed-end fund, you pay or receive this market price plus or minus a regular trading commission. You should recognize that the NAV and the market price of a closed-end fund are almost never the same! Over the long run, the market price of these shares has historically been from 5 to 20 percent below the NAV (i.e., closed-end funds typically sell at a discount to NAV). Exhibit 25.6 is a list of closed-end stock funds, includ- ing general equity funds; specialized equity funds; convertible securities, dual-purpose funds;
and world equity funds as quoted in Barron’s. The display also contains a listing of closed-end bond funds, including loan participation funds, high-yield bond funds, world income funds, national municipal bond funds, and single state municipal bond funds. Exhibit 25.7 breaks down the number of closed-end funds by category and AUM and indicates that a total of more than 600 such portfolios traded on U.S. exchanges by early 2002.
At the time of the quotes in Exhibit 25.6, most of the funds were selling at discounts to their NAV. This typical relationship has prompted questions from investors: Why do these funds sell at a discount? Why do the discounts differ between funds? What are the returns available to investors from funds that sell at large discounts? This final question arises because an investor who acquires a portfolio at a price below market value (i.e., below NAV) expects an above- average dividend yield. Still, the total rate of return on the fund depends on what happens to the discount during the holding period. If the discount relative to the NAV declines, the investment Closed-End
Investment Companies
1076
EXHIBIT 25.6 CLOSED-END FUNDS: PRICE QUOTATIONS
Source: Barron’s, 21 July 2001, Dow Jones & Co., Inc. Reprinted with permission.
CLOSED-END FUNDS: CATEGORIES AND AUM
STATISTIC VALUE
Total number of closed-end funds (U.S. exchanges only): 606
Total Assets*: 123,370.37
ASSETS BY CLASSIFICATION
CATEGORY ABBREV FUNDS ASSETS*
Corporate—High yield CHY 33 $7,351.89
Corporate—Investment grade CIG 4 $643.78
Emerging-market equity EME 4 $821.26
Emerging-market income EMI 7 $1,355.65
Equity income EQI 10 $1,085.56
General bd—Investment grade BDI 11 $1,593.24
General mortgage MTG 18 $9,025.49
Global equity GLE 9 $562.75
Global income GLI 27 $8,803.12
Government bond GOV 5 $2,463.79
Growth & income GCI 31 $11,549.06
Growth—Domestic GRD 82 $6,779.38
Loan participation LPF 5 $3,015.69
Multisector bond MLT 12 $5,031.71
Municipal—High yield MHY 4 $1,218.53
Municipal—National MNL 104 $31,292.02
Municipal single state MSS 129 $13,936.36
Non-US equity FOR 82 $11,562.27
Sector—Energy/natural res ENR 6 $474.82
Sector—Financial services FIN 8 $1,363.07
Sector—Health/biotechnology HLT 7 $844.27
Sector—Precious metals GPM 3 $376.99
Sector—Utilities UTL 5 $2,219.65
*Assets are net assets, expressed in millions, and exclude leveraged capital (preferred stock, debt, etc.), which totals about $28 billion.
Source: Closed-End Fund Association, 22 February 2002. Reprinted with permission.
EXHIBIT 25.7
should generate positive excess returns. If the discount increases, the investor will likely experi- ence negative excess returns. The analysis of these discounts remains a major question of mod- ern finance.5
5Studies over the years include Charles Lee, Andrei Shleifer, and Richard Thaler, “Investor Sentiment and the Closed- End Fund Puzzle,” Journal of Finance 46, no. 1 (March 1991): 76–110; Michael Barclay, Clifford Holderness, and Jeffrey Pontiff, “Private Benefits from Block Ownership and Discounts on Closed-End Funds,” Journal of Financial Economics 33, no. 3 (June 1993): 263–292; Burton Malkiel, “The Structure of Closed-End Fund Discounts Revisited,”
Journal of Portfolio Management 21, no. 4 (Summer 1995): 32–38; and Peter Klibanoff, Owen Lamont, and Thierry A.
Wizman, “Investor Reaction to Salient News in Closed-End Country Funds,” Journal of Finance 53, no. 2 (April 1998):
673–699. For a discussion of bond funds, see Malcolm Richards, Donald Fraser, and John Groth, “The Attractions of Closed-End Bond Funds,” Journal of Portfolio Management 8, no. 2 (Winter 1982): 56–61.
The interest in closed-end funds has led Thomas J. Herzfeld Advisors, a firm that specializes in closed-end funds, to create an index that tracks the market price performance of a sample of U.S. closed-end funds that invest principally in U.S. equities. The price-weighted series is based on fund market values rather than on NAVs. In addition to its market price index, Herzfeld also computes the average discount from NAV. The graph in Exhibit 25.6 indicates that the average discount from NAV changes over time and has a major impact on the market performance of the index. For example, from the third quarter of 2000 to the third quarter of 2001, this value changed from a discount of 7 percent to a premium of about three percent. Despite this, the per- formance of the Herzfeld closed-end average at the end of this period was ahead of the DJIA.
Open-end investment companies, or mutual funds, continue to sell and repurchase shares after their initial public offerings. They stand ready to sell additional shares of the fund at the NAV, with or without sales charge, or to buy back (redeem) shares of the fund at the NAV, with or with- out redemption fees.
Open-end investment companies have enjoyed substantial growth since World War II, as shown by the figures in Exhibit 25.8. Clearly, open-end funds account for a substantial portion of invested assets, and they provide a very important service for almost 200 million accounts.
Load versus No-Load Open-End Funds One distinction of open-end funds is that some charge a sales fee for share sales. The offering price for a share of a load fund equals the NAV of the share plus a sales charge, which can be as large as 7.5 to 8.0 percent of the NAV. A fund with an 8 percent sales charge (load) would give an individual who invested $1,000 in the fund shares that are worth only $920. Such funds generally charge no redemption fee, which means the shares can be redeemed at their NAV. These funds typically are quoted with an NAV and an offering Open-End
Investment Companies
1078 CHAPTER 25 PROFESSIONALASSETMANAGEMENT
OPEN-END INVESTMENT COMPANIES: NUMBER AND VALUE OF ASSETS: 1945–2000
NUMBER OF NUMBER OF
REPORTINGFUNDS ASSETS($ BILLIONS) REPORTINGFUNDS ASSETS($ BILLIONS)
1950 98 2.5 1988 2,127 471.4
1955 125 7.8 1989 2,262 552.6
1960 161 17.0 1990 2,338 566.8
1965 170 35.2 1991 2,583 850.7
1970 361 47.6 1992 2,960 1,096.3
1975 390 42.2 1993 3,614 1,504.6
1980 458 58.4 1994 4,362 1,544.3
1981 486 55.2 1995 4,728 2,058.3
1982 539 76.9 1996 5,260 2,624.0
1983 653 113.6 1997 5,671 3,409.3
1984 818 137.1 1998 6,288 4,173.5
1985 1,068 251.6 1999 6,746 5,233.2
1986 1,348 423.5 2000 7,116 5,119.4
1987 1,769 453.1 2001 7,292 4,689.6
Note: Does not include money market and short-term bond funds.
Source: 2002 Mutual Fund Fact Book, Copyright © 2002 Investment Company Institute. Reprinted by permission of Investment Company Institute (www.ici.org).
EXHIBIT 25.8
price. The NAV price is the redemption (bid) price, and the offering (ask) price equals the NAV divided by 1.0 minus the percent load. For example, if the NAV of a fund with an 8 percent load is $8.50 a share, the offering price would be $9.24 ($8.50/0.92). The 74-cent differential is really 8.7 percent of the NAV. The load percentage typically declines with the size of the order.
A no-load fundimposes no initial sales charge so it sells shares at their NAV. Some of these funds charge a small redemption fee of about one-half of 1 percent. In The Wall Street Journal, quotes for these no-load funds list bid prices as the NAV with the designation “NL” (no load) for the offering price—that is, the bid and offer are the same. The number of no-load funds has increased substantially in recent years. The Wall Street Journal lists more than 350 no-load funds, and Barron’s lists more than 800.
Between the full-load fund and the pure no-load fund, several important variations exist. The first is the low-load fund, which imposes a front-end sales charge when the fund is bought, but it is typically in the 3 percent range rather than 7 to 8 percent. Generally, low-load funds are used for bond funds or equity funds offered by management companies that also offer no-load funds.
For example, most Fidelity Management funds were no load prior to 1985, but several of their newer funds have carried a low load of 3 percent. Alternatively, some funds—previously charg- ing full loads—have reduced their loads.
The second major innovation is the 12b-1 plan, named after a 1980 SEC ruling. This plan permits funds to deduct as much as 0.75 percent of average net assets per year to cover distribu- tion costs, such as advertising, brokers’ commissions, and general marketing expenses. A large and growing number of no-load funds are adopting these plans, as are a few low-load funds. You can determine if a fund has a 12b-1 plan only by reading the prospectus or using an investment service that reports charges in substantial detail.
Finally, some funds have instituted contingent, deferred sales loadsin which a sales fee is charged when the fund is sold if it is held for less than some time period, perhaps three or four years.
In addition to selling charges (loads or 12b-1 charges), all investment firms charge annual man- agement feesto compensate professional managers of the fund. Similar to the compensation structure for private management firms, such a fee typically is a percentage of the average net assets of the fund varying from about 0.25 to 1.00 percent. Most of these management fees are on sliding scales that decline with the size of the fund. For example, a fund with assets under
$1 billion might charge 1 percent, funds with assets between $1 billion and $5 billion might charge 0.50 percent, and those over $5 billion would charge 0.25 percent.
These management fees are a major factor driving the creation of new funds. More assets under management generate more fees, but the costs of management do not increase at the same rate as the managed assets because substantial economies of scale exist in managing financial assets. Once the research staff and management structure have been established, the incremental costs do not rise in line with the assets under management. For example, the cost of managing
$1 billion of assets is not twice the cost of managing $500 million. Finally, one consequence of the industry consolidation we discussed earlier is that mutual fund fees have been declining. For instance, the Investment Company Institute reported that between 1980 and 1998 total share- holder costs to equity fund investors decreased by 40 percent, from 2.25 to 1.35 percent of aver- age fund AUM.