KEY POINTS:
Summer is coming and the local stockmarket is hitting new highs - the perfect time to list a closed-end fund.
Last month, sensing the stars were aligned, Fisher Funds Management floated their second locally listed closed-end investment fund, Barramundi.
Barramundi will invest in Australian small companies. The fund, also known as an investment trust, is potentially a useful investment vehicle, and is thus popular with experienced retail and institutional investors.
A closed-end fund is essentially just a managed fund which has been listed on the stockmarket, but they have a few unique characteristics, some of which are good and some not so good.
Firstly, the price of such a fund is usually a bit more volatile than your average unit trust, and because their promoters need a good recent track record to get the initial sale away, the funds often appear on the scene just as their market is peaking.
Anyone who bought a technology closed-end fund in 1999 will be familiar with this phenomenon. This fact, and the tendency for a fund's share price to revolve around its net asset value, sometimes above, often below, means that buying into a new fund before its listing needs to be considered carefully. Closed-end funds have been popular and important parts of the British and US stockmarkets for more than 100 years. Their attractions to Mum and Dad relative to unlisted funds include much lower annual fees, a tendency to trade at discounts to their net asset value (you can get $1.10 worth of assets producing income for your $1), an independent board of directors looking after your interests and, in British funds, much better levels of disclosure than from a unit trust.
The tendency for a fund to trade on the stockmarket above or below its asset backing needs to be understood by anyone looking at these funds as a long-term investment.
Lets look at City of London (TCL), a very old UK investment trust (1891) which invests in blue-chip British shares and is listed in London and on the NZX.
Recently TCL's share price was $8.40. But the portfolio of shares it owned were worth $8.90 a share. How do we know? Because every day TCL announces its asset backing per share to the London and NZ Stock Exchanges.
The significance of this difference is twofold. First, you get $8.90 of assets working for you and producing income for your $8.40. Secondly, the differential between the price and the NAV (known as the discount) could narrow, which would be good for TCL shareholders who need to sell, or widen, which is bad news if you have to sell. That is the principal reason that the share price of closed-end funds can be more volatile than managed funds. Thus closed-end funds aren't for the nervous or people with short investment horizons. The point with CEFs is that when they are good they are very good, but when they are bad they can be very bad.
The longer your investment horizon, the less relevant the volatility and the more important the fundamental strengths of the CEF
Foremost among these advantages are low running costs (about o.4 per cent yearly for TCL), which means that unlike their higher cost unit trust cousins, many funds have enough income left over after running expenses to pay a decent dividend.
What's more, some have the further objective of increasing their dividends faster than inflation - handy if you are living off your investment income, as many retired people are.
TCL pays a quarterly dividend to yield 3.4 per cent, and raised its dividend by 11 per cent last quarter.
This dividend aspect of many international closed-end funds may become more important under Finance Minister Michael Cullen's fair-dividend tax: because the funds usually have lower fees, more income is left over to pay the fair dividend tax accessible on Mum and Dad shares.
The funds have other attractions - investment trust shareholders have the same rights as shareholders in any other publicly-listed company. The shareholders own the company, so it's up to them to choose directors and approve important changes to investment strategy and structure.
In Britain and Australia the larger investment trusts have tended to appoint some of their country's leading businessmen as "independent" directors to protect minority shareholders.
This "independence" concept is extremely important to shareholders given the potential for conflicts of interest which could arise for the directors of the investment trust company who are also directors or employees of the management company, particularly at times when investment decisions are made or when management contracts are being reviewed or renegotiated.
Volatility aside, closed-end funds are in many ways ideal for Mum and Dads' long-term investment.
City of London has a reasonably simple capital structure, so it is easy to see its net asset value. But many funds have more complex structures involving the issue of warrants.
Warrants are the right to buy a new share in a fund at a fixed price at some specific date in the future. Fund promoters often issue warrants as a bonus to new subscribers, just in case the market price of the fund on listing falls below issue price.
This is the first part of a two part series. In two weeks we will see who pays for the "free" warrants and look at the reasons why most funds trade at discounts.
