One hot topic in the closed-end fund world the past few years has been buying funds on the IPO. This is the primary way in which a new CEF is born. About a year ago, Morningstar did a study with the premise that CEF IPO investors didn't lose money if they held onto the fund for a long time. The article was done in two parts and you can read them here: Part One and Part Two. While I would agree that they make some good points, a few questions lingered.
- How did investors do if they had delayed their entry into the fund post IPO?
- Are there certain time periods in which the CEF structure tends to do better than a peer ETF? This is also an attempt to take the market movements out of the results and focus on the structural differences in owning a CEF vs. an ETF or open-end fund.
To begin, we selected potential entry points post-IPO. They were (in calendar days): on the IPO date, 1 week, 45 days, 90 days, 180 days, 270 days and 1 year post-IPO. The reason for these entry points was simply to provide points that we could easily remember going forward if the study proved enlightening.
To test these entry points, we examined the returns of each of the funds exactly 2 years post-IPO if the investor had entered at each of the above-mentioned dates (imagine standing two years down the line from the IPO date and looking back to each of these entry points and entering then). Next, we netted out the returns of the market to isolate the potential "alpha" that these funds provided. To do this, we matched comparable ETFs for each type of fund and subtracted out the returns from the same dates that we were examining in the CEF. This way, we could see the actual effects and performance of the fund, and possibly the market forces on the fund on and after the IPO date.
We examined several types of CEFs. The categories of funds we studied were: US equity, global equity, US REIT, International REIT, MLP, municipal bond, junk bond and senior loan bond. We had to find CEF sectors that had tracking ETFs available for a two year period with enough funds to make the comparison about the structure vs. the individual fund results. We used a 20 year look back because about 70% of funds have IPO'ed since March 1993. In total we examined 51 funds. A full list of funds examined is available upon request.
From these results, we see that of these entry points, entering 270 calendar days post-IPO is historically the best day to enter. Before the study, we suspected it would be after the 45 day Greenshoe option and once the fund was able to trade on pure market forces. This is the share over-allotment option that allows underwriters to short sell shares at the offering price and usually accounts for 15% of the IPO'ed shares.
We also thought it might be about six months, just before the fund released its first semiannual report. One of the main reasons we believed it would be between 180 and 365 days was that after the fund has one year of market data and a full annual report, we had noticed - and now proved - that the CEF typically has more buying interest post 12 months. We believe this stems from the fund having more comparable data for peer analysis and more insight into what the portfolio manager is doing with the fund's assets. This higher amount of transparency can easily lead to higher prices vs. NAV and buying before this occurs can improve your returns as long as you are willing to take some added risk in having less transparency.
One other point of note is that we can start to see around 45 days post-IPO that fund-specific returns begin to become positive. This agrees with one of our original hypotheses that the Green Shoe props up the market price, while post Green Shoe, most funds start trading at discounts to NAV. The IPO commission to bring the stock to market is usually about 4.5% of NAV.
Examining this chart, the next logical step was to find the best day to enter post-IPO, i.e. which day post-IPO, on average, yields the best fund-specific return (we also found the worst day to invest). We did this by calculating the net return (return of the fund minus return of the comparable ETF) of the fund if the investor were to enter the fund at any of the days within the two-year window. We performed this on the same group of funds that we described above. We also calculated the actual average and returns for the investors if they were to enter in at the best and worst days. The sector-specific results were as follows for each sub group.
As seen in the data above, the results for the actual "best" and "worst" day to purchase the fund in the various sectors can vary.
We can be wrong in our prediction that CEF IPOs are never more profitable when purchased at a later date. They key is that we were often correct. It is worth noting the January 2012 DoubleLine Opportunistic Credit Fund (DBL) IPO as an example.
We recognize that our research focused on the average experience for the average fund and some funds are actually successful at never breaching NAV and holding a premium. The January 27, 2012, IPO of DBL is a perfect example. Its lowest premium has been +4.01% since IPO and has never breached its IPO price of $25 per share. In our experience it is always possible to find exceptions to the rule or common experience, but investors should be cautious when they buy a CEF IPO. They are far less likely to lose a large amount of capital, but they are unlikely to do better than waiting a few months for better pricing. One thing we can't stress enough for CEF investors is doing your homework and being patient and diligent in your research and portfolio management.