Articles Posted in Closed-End Funds

In last week’s blog post about closed-end mutual funds [click here for blog post], I warned investors about paying a premium when investing in a closed-end fund’s initial public offering (IPO) and suggested that the most prudent thing to do is invest after the IPO. According to the Closed-End Fund Association (CEMA), IPO fees generally range from 4.5%-4.75%.

Although closed-end funds offer liquidity, investors should view a closed-end fund IPO as a long-term investment. Most problems arise when closed-end funds are traded on a short-term basis. Of the six recently issued IPOs listed below, only the Goldman Sachs MLP Income Opportunities Fund is currently in positive territory, trading about 1% above its IPO price. However, since the Goldman fund began trading just two weeks ago, the jury is still out on how well IPO investors are going to fare both near-term and long-term. As mentioned in a previous blog post, investing in a closed-end fund IPO is almost always a losing short-term bet.

ClearBridge American Energy MLP Fund [CBA] (-18.20%)

investor alert.gifLooking for higher returns often means looking for trouble. Some financial advisors seeking to offer investors higher yields have been turning to closed-end funds, which can offer distributions as high as 6%. Unsophisticated investors frequently confuse closed-end funds with standard mutual funds, referred to as “open-end funds.” Closed-end funds are complex investment products that carry unique risks that may be inappropriate for more conservative investors. Last month, FINRA, the overseer of the financial industry, issued an Investor Alert urging investors to proceed with caution when investing in closed-end funds. (See “Related Links” below.) Unlike mutual funds, closed-end funds are typically offered through an initial public offering (IPO). After the IPO, closed-end funds trade like stocks. However, as FINRA noted in their alert, investors pay a premium when buying shares in a closed-end IPO. We blogged about this issue back in July 2009, based on a study by Lipper Research explaining that market prices for closed-end funds often plunge after the IPO. (See “Related Links” below.)

If you are still convinced that investing in a closed-end fund IPO is a good idea, read this post: Closed-End Fund IPOs Often Give Investors the Short End of the Stick

What is a risk-averse investor to do? Make sure that the fund is suitable based on your financial situation, risk tolerance and investment objectives. Although there is no guarantee that a post-IPO plunge will lead to a subsequent gain, consider investing after the IPO. Finally, if getting in on the closed-end fund IPO is simply to good to pass up, go in with the understanding that this should be a long-term investment that may take time before premiums paid at the IPO can be recouped.

Before discussing the Financial Industry Regulatory Authority’s (FINRA’s) latest action against Merrill Lynch and UBS, I want to share a related story about a client at my San Mateo, California, securities law practice who had invested a substantial part of her portfolio in a Closed-End Fund (CEF) that, unknown to her, was purchased as part of an Initial Public Offering (IPO). The client, who had recently been widowed, had made a large deposit in her brokerage account following the sale of her deceased husband’s business. Needless to say, the widow wanted to proceed cautiously and preserve her capital. Unfortunately for the widow, the broker did not share with her the “dirty little secret” about investing in CEFs:

Customers who invest in Closed-End Funds at the IPO almost always suffer an immediate loss.

This came as a shock to the widow, but it is a well known fact within the industry and is supported by a large body of research going back over 20 years. The reason is simple. CEFs almost always trade at a discount to their Net Asset Value (NAV) in the secondary market. However, when an IPO is structured, the fund’s offering price is typically set at or above the NAV. Thus, the fund’s price usually plunges after the IPO when the shares begin trading in the secondary market. See e.g., Lipper Research Report, “Buying a Closed-End Fund Initial Public Offering: Caveat Emptor!” (November 8, 2004)

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