Indexing was conceived as a response to market efficiency. If the stock market is perfectly efficient (all available information is instantly reflected in stock prices), then it’s impossible to beat the market, and the best you can do is to minimize your fees, trading costs and taxes by buying index funds. But are there areas where you really can beat the market? As you can imagine, this has been a topic of lively debate among academics for a while.
There’s considerable literature about small cap stock funds, for example: some research suggests that small cap fund managers can consistently beat their benchmarks because greater information inefficiencies (and thus opportunities) exist in small cap stocks. If you take this view, then you can replace the small-cap index ETF in your portfolio with an actively managed diversified small cap mutual fund. Many people disagree, however, and some recent literature suggests that small cap managers don’t beat the market when you take account of transactions costs and better define the indexes against which they are benchmarked. Personally, I believe that if small cap managers focus on few enough stocks, they can consistently beat the market, particularly given current market inefficiencies. That’s the basis for Tech Uncoved; the problem is that many fund managers are forced to diversify to the point where they cannot adequately research the stocks they buy.
One area, however, where it seems there are clear inefficiencies is in closed-end mutual funds. Closed-end funds are mutual funds that have a fixed number of shares that trade on a stock exchange. If you want to buy shares in the fund, you have to buy them from someone else. This is in contrast to standard, open-ended mutual funds where you buy shares by adding capital to the fund, and the fund issues new shares. (ETFs, by the way, are a hybrid between closed-end and open-end funds.) The key point for our present purpose is this:
- A traditional, open-ended fund always trades at a price that reflects the current value of the assets in the fund (known as the net asset value, or NAV).
- An ETF usually trades at NAV, and never diverges significantly from that value.
- Importantly, a closed-end fund can trade at a significant premium or discount to NAV.
The latter can happen for a bunch of reasons. If the fund manager is totally lousy, for example, then you can assume that s/he will consistently lose money for the foreseeable future. In which case, even if the assets of the fund are worth a lot now, you know they’ll be worth less later. So, since owners of the fund’s shares cannot redeem their shares for cash but are forced to sell to someone else, the buyers they’ll find will probably want to pay less than the current underlying asset value.
So why would anyone want to set up a closed-end mutual fund? I’ve always imagined that it must be pretty embarrassing to run a closed-end fund trading at a discount to NAV. It’s like walking round with a sign on your forehead that says “Hi! I’m a lousy fund manager and my investors expect me to lose money”.
Well, the rationale for closed-end funds is as follows. Some types of investment are relatively illiquid. In an open-ended fund structure, the manager must buy and sell whatever the fund invests in to respond to inflows and outflows of capital as investors purchase or redeem fund shares. But this would be difficult and costly for funds investing in relatively illiquid assets. So (the argument goes) it’s beneficial for investors to have the capital base of the fund fixed, and for purchases and sales to be transacted between investors on an exchange without involving the fund itself. Also, some closed-end funds use leverage (ie. borrow money) to buy assets, and the closed-end structure lends itself well to that.
For our purposes, the phenomenon of closed-end funds trading at a discount to the value of their underlying assets has three attractions. First, a number of closed-end funds specialize in stocks of a single-country outside the US and Europe. Arguably, these markets are less liquid than the US and European stock markets. So more of a case can be made for active management as opposed to indexing, particularly if the fund manager is totally focused on a single-country (rather than a global fund, for example, or a multi-country “emerging markets fund”). Remember Yale Endowment manager David Swensen’s view: “The advisability of active management for marketable securities runs the gamut of completely-out of the question for fixed income, to questionable for large-capitalization domestic equities, to nearly required for emerging market positions [my italics].”
Although it’s a backward-looking metric, you can try to evaluate the fund manager by comparing the fund’s historical performance to the country benchmark. In principle, therefore, we may be interested in actively managed single-country funds.
Second, country funds seem to go in and out of favor, and this is attractive for longer term investors. In late 2002, for example, there was much speculation about conflict between India and Pakistan. As a result, the Indian stock market fell, but on top of that the closed-end funds that invest in India traded at wider than usual discounts to net asset value. In other words, there was a double buying opportunity: Indian stocks themselves became cheaper, plus the discount at which you could buy them in a closed-end fund also widened. When the worries subsided, the Indian stock market traded up and the closed-end fund discount narrowed. Longer-term investors can therefore purchase shares in fund focused on “out of favor” markets, and sell when the markets regain wider investor favor.
Third, there’s a strong argument for using closed-end funds or ETFs rather than traditional mutual funds for foreign stocks: the absence of fund arbitrage. Let me explain. Individual investors buy or sell shares in traditional mutual funds after the close of the US stock market each day. The price at which traditional mutual fund shares are bought or sold is determined by the closing prices of the stocks that make up the mutual fund. Together, those prices determine the net asset value ("NAV") of the traditional mutual fund, and thus the price at which fund shares are transacted after the market closes.
But here’s the problem. Imagine that you are interested in a US mutual fund that invests in British stocks. Britain is five hours ahead of US Eastern Standard Time. When the US stock market opens at 9.30am EST, it’s 2.30pm London time. When the US market closes at 4.30pm EST, it’s 9.30pm London time. Now, suppose that British stocks end down when the British stock market opens; but subsequently, in the hours between 4pm London time and 9.30pm London time the US stock market has a huge rally. Guess what? Chances are that UK stocks will open higher when the London market opens the next morning, given the rally in US stocks. But you can buy shares in the US-based mutual fund that invests in British stocks at the NAV determined by the closing prices of stocks in London, not New York. In other words, you can buy fund shares at an old, outdated NAV, knowing that they are really worth more.
If this sounds overly complex yet of trivial value, consider this. Eric Zitzewitz, a professor at Stanford University, estimates that arbitrageurs who take advantage of this mis-pricing can make 30% to 80% a year. That profit comes directly out of the pockets of the longer term investors in US-based foreign stock funds. Longer term investors have lost about $5 billion to arbitrage (!), equivalent to about 1.1% annually in broad international funds and 2.3% annually in regional funds.
The underlying cause of this loss is that the funds’ NAVs (or estimated NAVs based on changes in US stock prices) are not updated during US market hours. In contrast, closed-end funds and ETFs trade during US market hours, so the market price of the fund changes and no arbitrage opportunity exists. When the US market rallies, the shares of single-country closed-end funds tend to rise, despite the fact that in many cases the stocks held by those funds are not yet trading on their local exchanges due to time differences. So a clear advantage of using closed-end funds (or ETFs) rather than traditional mutual funds for foreign stocks is that no opportunity exists for arbitrageurs to loot value from longer term investors.
In aggregate, these three factors make closed-end, single-country funds trading at discounts to net asset value attractive. International markets can be less efficient than domestic markets, so active management makes more sense for those markets. Closed-end single-country funds go in and out of favor, so longer-term investors can buy them at deep discounts to NAV and hold them until the discount narrows. And closed-end funds are well suited to international stocks as they avoid the loss of value from arbitrage that plagues traditional mutual funds.