Daniel Lippincott, The Daily Record Newswire
Everything in the financial world seems to be getting better these days. The economy appears to be slowly improving, the unemployment rate is inching lower, and the stock market is at an all-time high. Even the closed-end fund industry is experiencing a recovery in the rate of initial public offerings.
The closed-end fund industry experienced large and frequent IPOs from 2003-2005, averaging more than $24 billion in new issuance per year. The abundance of new issuance was driven by the demand for investment income amidst the low rate environment.
Then in 2007, the industry witnessed more than $27 million of new closed-end fund issuance. Due to international equity markets significantly outperforming U.S. stocks for several years leading up to 2007, the majority of this new issuance focused on quenching the demand for global equity funds.
Then suddenly in 2008, new issuance of closed-end funds came to a halt. The financial crisis caused retail investors to ditch closed-end funds and other investment vehicles in favor of safe haven assets such as certificates of deposit and Treasury bonds. In fact, the $27 billion of new issuance from 2007 was more than the new issuance from 2008 to 2011 combined.
Demand for new closed-end funds appears to be on the rise again. There was $11 billion worth of IPOs in 2012 and over $6 billion so far this year. Additionally, there are approximately 30 new funds coming to the market in the near future. Should an investor participate in an IPO for a closed-end fund if given the opportunity?
First, let’s look at a recent closed-end fund IPO. The fund priced at $20 per share. Of this $20, 90 cents was used to pay for underwriting fees. Underwriting is the process by which investment bankers raise capital from investors on behalf of funds that are issuing securities. After deducting the underwriting fee, the fund is left to invest only $19.10 of your original $20 investment. In this case the investor is paying a premium of 4.5 percent to participate in this fund’s IPO.
Secondly, the prices of new funds are usually supported by underwriters for a month or two. Additionally, new closed-end funds often come with a “teaser” dividend rate in order to attract investors. While underwriter support and an artificially high dividend will initially support the market price of a closed-end fund, history shows that when the underwriters cease to support the fund and the dividend is cut to an appropriate level, the fund will usually decrease in value.
Lastly, new closed-end fund IPOs are usually focused on the “flavor of the day” investment, meaning an investment that has performed well over the past few years. For instance, the overwhelming majority of the upcoming IPOs focus on multi-sector and high-yield fixed income. Retail investors are chasing investments that have performed well recently and the closed-end fund industry is meeting the demand. As an investor it is generally a better idea to look for undervalued assets as opposed to chasing after the top performing assets of the past few years.
So when your broker tries to sell you on the newest, hottest, most promising fund, you would be better off hanging up the phone. Instead, wait for the naive IPO investors to sell and drive the price down, then buy the fund at an attractive discount to net asset value. For these patient value investors, the increased supply of new closed-end funds coming to market should continue to create ongoing opportunities.
—————
Daniel Lippincott is a senior tax sensitive manager/director of investment personnel for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
