There's $30 billion in spreads between the market caps of closed-end fund and their net assets. How do you get a piece of this money?
Discount hunter
By Thomas Easton
ONE OF THE GREAT MYSTERIES of Wall Street is what determines the relationship between the liquidating value of a closed-end fund and its trading price on the stock exchange. Unravel this enigma and you can make a small fortune.
Alexander Zagoreos, a New York City-based partner of Lazard FrŠres & Co., devotes full time to this enigma, and performance numbers suggest that he has more of a clue than the average investor about what's going on. Zagoreos, 60, has been trading in and out of closed-end funds since 1984, via a limited partnership that has $257 million in it. Performance: 15% annually.
Zagoreos also manages the $163 million World Trust Fund, a closed-end fund of his own that owns nothing but shares of other closed-end funds. World Trust has a global portfolio of 51 closed-ends, 30 of them non-U.S.-traded funds. In the seven years that Zagoreos has been running the London-listed World Trust, it has delivered a compound annual 12%, more than two percentage points ahead of Morgan Stanley's benchmark EAFE Index and just a tad behind Morgan Stanley's Global Index, which has a vastly larger weighting in the U.S.
The pond that Lazard fishes in is enormous-1,100 funds with a combined $190 billion in net portfolio value. The combined market capitalization of these funds is only $160 billion. That leaves $30 billion of value to go after.
Some portion of that $30 billion spread is entirely rational: Owners of closed-end shares are a captive audience, forced to pay management fees to a portfolio manager who may not be doing a good job. Fees averaging 1.1% a year explain some of the 17% average discount on the closed-ends owned by World Trust. And let's not forget World Trust's own layer of costs, which run to 0.8% a year. That drag on returns may partly explain the 11% discount to net asset value at which World Trust trades.
But fees aren't everything, and they don't explain the investor moods that push discounts up and down. At the moment, Zagoreos says, the climate for buyers is good: Worldwide, the discounts among closed-end funds are the widest they've been in five years. But don't buy blindly, says Zagoreos. Look for a fund where it is reasonable to expect some narrowing of the discount over the next several years.
Sometimes, the discount vanishes: when a closed-end either dissolves, distributing its net assets to its shareholders, or becomes liquid in a less violent fashion by open-ending. In the latter case, the shareholders are given the same right to cash out at net asset value that all open-end funds offer.
In a halfway step to open-ending, the operator of a closed-end may use some of the fund's assets to buy in their own shares as a way of pushing up the share price and providing an exit ramp for disaffected holders. Share buybacks tend to shrink the discount but not eliminate it. Usually, the investment outfit operating a closed-end fund is not thrilled with the idea of opening it; if a lot of formerly captive customers head for the exit, the pool of assets on which the manager collects a percentage fee will suddenly shrink.
Playing closed-end funds.
Fund Discount Where traded
Fold
Emerging Germany 19% New York
Europe Fund 16 New York
Italy Fund 20 New York
Spain Fund 17 New York
Swiss Helvetia 21 New York
Hold
Aberdeen Emerging Asia 19 London
East Europe Development Fund 24 Dublin
Edinburgh New Tiger Trust 26 London
Greek Progress 19 Athens
Value Realization Trust 9 London
Source: Lazard FrSres.
As it happens, roughly 40 of the 51 closed-ends in the World Trust portfolio are either enmeshed in a restructuring or are being seriously pressed by outsiders to open-end or do some buybacks. This year alone four funds in the World Trust, all London registered, were forced open, and three more (one in London, the other two in New York) are scheduled to do so this year. The table above lists other World Trust holdings where prospects are good for an open-ending, in Zagoreos' view.
Here's one reason for an open-ending. A closed-end was created years ago to participate in an illiquid stock exchange, but that stock market has matured and no longer demands a closed-end structure as a vehicle for foreigners to invest through. Cases in point: the Italy Fund (20% discount) and the Swiss Helvetia Fund (21%). There's no certainty that either of these will go open, but at least the sponsors can't make as compelling a case as they used to for standing pat.
Zagoreos isn't just a trader. He is also willing to make long-term bets on closed-ends that really do have a reason for being, meaning they operate in very chancy, illiquid markets that are hard-pressed even to clear stock trades in an orderly fashion. We're talking about India, Latin America, Eastern Europe and even Russia.
Yes, Russia has cost Zagoreos 1% to 2% of the fund's net asset value in recent months, but he's planning to hang in there. At present prices, listed Russian stocks are worth maybe $28 billion-half the market cap of Greece, which has a much smaller economy.
If you do want to participate in a Third World market, look far and wide for the right fund. Luxembourg-listed First NIS Regional Fund, which invests in eastern Europe, trades at a 31% discount; the more accessible Templeton Russia Fund, which trades on the New York Stock Exchange, sells at a 39% premium. That's not unusual.
"Shop only in New York and you miss many of the best deals," Zagoreos says.
One caution. It can be a real tax headache to own a foreign-domiciled fund in a taxable account. Zagoreos recommends trying to hold these things in a self-directed IRA, 401(k) or the like.
Hey, what about the World Trust's own 11% discount? When is Zagoreos going to open-end the thing and deliver a nice little windfall to his shareholders? At 8% to 10%, he started buying back shares. It's a first step.
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