I understand that it shouldn't matter when an open-end fund has an initial public offering because its price is based entirely on net asset value. But what about closed-end funds? For instance, I'm getting in on the IPO of the meVC Draper Fisher Jurvetson fund, which will make mostly private investments. I didn't buy it with the hopes of an IPO pop, but... -- Adam Cutler
If closed-end stock funds would rocket when they go public, they would certainly be more popular.
Alas, most do not. These days, they are more like
As I noted in
last Thursday's column, the price of an open-end mutual fund won't leap like stock offerings sometimes do on the first day of trading. The price of a closed-end fund can theoretically pop, but it usually won't. Only overwhelming demand could do that -- something that's hard to come by with closed-end stock funds.
Here's a brief explanation of the difference between open-end and closed-end funds:
Shares of open-end funds are, for all intents and purposes, unlimited. An open-end fund's price is based on the total value of the fund's holdings, divided by the number of shares outstanding. Most mutual funds you read about are open-end funds.
Closed-end funds have a fixed number of shares and trade on exchanges like stocks. These shares are priced based on the supply and demand of the market rather than the value of what a portfolio owns. Shares can trade above or below the market value of the fund's holdings.
However, the vast majority of closed-end funds trade at a discount to their net asset values, or NAVs, meaning their shares are worth less than their actual holdings. Of the 497 closed-end funds tracked by
, only 32 are trading at a premium. That leaves an astounding 94% of closed-end funds trading at a discount.
And the same thing will likely happen to a new fund's share price.
"There is so much bad history of closed-end funds going to a discount that they tend to drift lower," says Don Cassidy, a closed-end fund analyst at
Oftentimes, a firm is bringing out a fund at the top of the market, adds Kevin McNally, a closed-end fund analyst at
Salomon Smith Barney
For example, a glut of closed-end high-yield bond funds hit the market in 1998. During the first seven months of 1998,
Salomon Smith Barney
Donaldson Lufkin & Jenrette
each launched a high-yield fund. That was right before Russia defaulted on its debt, which led to people pulling out of riskier instruments.
In other cases, the brokerage firms involved in offering a closed-end fund have sold so many shares that no one is left to buy it once the fund starts trading. No demand equals a trading discount.
Van Kampen Senior Income Trust
, for example, raised almost $2 billion when it went public in June 1998. The corporate-loan fund is currently trading at a discount of almost 16%.
"When you issue almost $2 billion in securities right off the bat, that is an extremely big fund and it dilutes any near-term demand," says McNally.
Some closed-end funds might start trading at a slight premium to their NAV, but only because the underwriting fees and other initial expenses have been deducted from the fund's net assets, which creates an automatic price premium.
For a fund to experience a rapid run-up on its first day of trading, the market must value those shares at a hefty premium to its NAV. Some extraordinary conditions would have to exist to see that kind of performance.
"It might only happen if the fund is offering something unique," says McNally.
A fund might see this kind of demand if it invests in a country that others don't.
Shortly after the Berlin Wall fell in 1989, a few closed-end German funds came out, including the
fund. It immediately shot to a 40% premium to NAV, says Lipper's Cassidy. These days, that fund is trading at a 23.8% discount.
But that was a decade ago. You'd be hard pressed to find that kind of success lately.
Last year, 33 new closed-end funds went public and just two of them were stock funds, according to
. The remaining 31 were bond funds. By comparison, 123 new U.S. open-end stock funds came out last year, according to
One of those two new closed-end stock funds seemed to fit the criteria for an IPO pop: the
LCM Internet Growth
. Hot area. Great demand
This fund went public in November of last year, raising just $37.4 million, and its price fell to a discount, says Kevin Rowland, an analyst with Wiesenberger/Thomson Financial. It is, however, the only one of the 33 funds showing a price increase since inception. The fund went public at $10 a share. The shares are now trading at $11.63, compared with an NAV of $14.18, a discount of 18%.
So if you bought at the offering price, you haven't lost money. However, your shares have not kept up with the value of the fund's portfolio.
Of the few funds that are currently trading at a premium, several are unique country funds, including the
Back when the emerging markets blew up a few years ago, the NAVs of these funds fell so dramatically that their market prices couldn't catch up on the downside, and their premiums reached 100%, says McNally. "Investors were not willing to sell at such low prices." They have been able to maintain those premiums even today.
Frankly, closed-end funds are plagued by disadvantages and complexities that open-end funds don't carry. Their structure is difficult to understand, most carry these pesky discounts and information and price data are hard to come by.
Actually, the meVC Draper Fisher Jurvetson fund mentioned above is the first unique closed-end stock fund to come along in a while.
This venture capital fund will make investments in private technology companies, such as Internet and telecommunications businesses. As its name indicates, it is backed by
Draper Fisher Jurvetson
, a well-known venture capital firm. (See a previous
story for more about the fund.)
However, this fund probably didn't have much choice regarding its structure. A fund that's only buying private equity and is being sold to retail investors has to be structured as a closed-end fund. An open-end fund can't have more than 15% of its assets in illiquid securities, says Pamela Wilson, an attorney with
Hale and Dorr
The meVC fund has already raised $330 million in an initial public offering, but the shares won't start trading until around July 1. The fund will take about two years to be fully invested and will carry a high cash component during its first year. Buying private equity is, after all, a lot more complicated than buying stock that trades on an exchange. (The fund's also charging a 2.5% annual fee, plus the managers get to keep 20% of the profits.)
This fund sounds unusual enough to get a bounce when its shares hit the market.
"The fund is unique. Maybe it is the one that goes up. I don't know," says McNally.
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