Make Money with Closed-End Fund Activism

Closed-end fund shareholders have traditionally been thought of as individual investors. But when last year's market turmoil sent discounts to record levels, according to a December 2008 survey by Herzfeld Advisers and the Altman Group, "market conditions have caused retail investors to flee closed-end funds and thus paved the way for institutional investors to get their way through increased shareholder activism." The potential immediate profit from open-ending or liquidating a CEF trading at a discount of 15% or so is quite attractive, even though trying to force through changes over the opposition of incumbent fund management resembles medieval siege warfare in its demands on time, resources and strategic planning.

One strategy that individual investors might consider would be to piggy-back on institutional activism, buying those CEF's that seem to be most susceptible to discount reduction action in the near future. The factors that identify target funds might include:

• How large is the trading discount? (Bigger discount = more incentive to act.)
• How large is the fund? (The profit from closing the discount on a very small CEF might not be worth the effort, and even institutions might find it difficult to build positions in the largest CEFs. Hunters don't usually stalk mice or hippos.)
• Is there any clear benefit from keeping the closed-end format? (For instance, an illiquid portfolio or many hard-to-value holdings?)
• Is the fund an acceptable holding even if the discount doesn't change?
• What are the underlying investments? (Stock funds have bigger discounts, but bond fund returns are more predictable for investors and activists.)
• Has the CEF consistently beaten its benchmarks? Or is it a loser?
• How much do institutions own? (They must file Form 13F every quarter to report holdings, and various online services summarize and analyze this data.)
• Are the institutional owners willing to support discount reduction activism? (Many are brokers or sponsor other CEFs, and prefer the status quo.)

Over the years a few courageous souls have developed reputations for getting results as CEF activists: Phil Goldstein of Bulldog Investors, George Karpus of Karpus Management and Art Lipson of Western Investments are regular names on SEC filings that disclose >5% ownership of a fund or the start of a proxy contest. But in addition. there are over a dozen more hedge fund-type institutions with assets in the $100 million+ range that keep showing up on CEF shareholder lists, where a review of their portfolios shows that they specialize in or emphasize owning CEFs.

The 13F filers that appear to have the most to gain from discount reductions include the following names, in addition to Karpus and Western (Goldstein's Bulldog Investments does not file 13F forms): 1607 Capital, City of London, Cornerstone, Doliver, Financial & Investment, Gramercy, Punch Associates, Relative Value, Rivernorth, Rockwood, Summit Capital, Technical Financial, Wolverine and Yieldquest. These secondary players, who altogether control over $5 billion, are not nearly as well known as the leading activists: they keep their ownership of CEF's under the 5% threshold for filing a Schedule 13D or 13G, and they appear content to profit by playing "follow the leader". Their support may be crucial in CEF proxy contests, where the voting turnout by individual investors tends to be quite low. As the Investment Company Institute reported back in 2007:

Even though closed-end fund shareholders are solicited annually by their funds to elect directors, many shareholders still do not vote.... for half of closed-end funds, beneficial owners voted at most 31% of their shares held in street name.

To test the potential for institutional activism, ten CEFs were selected for examination: ASG, DHG, FGF, GRX, HQH, NFJ, RTU, SCD, SLS and USA. All are US equity or equity-income funds that have recently traded at discounts above 15%. An online database of 13F filings as of 6/30/09 showed total institutional holdings were more than 15% for all but one of these funds (GRX). The high was the 36.7% institutional ownership of FGF, a multimanager growth equity fund organized in July, 2005 with a current market cap @ $200mm and a recent trading discount of about 16%. The sixteen institutional investors listed above, i.e. activists and followers, together appear to own about 18% of FGF.

Any predictions? Anyone want to bet whether FGF will be the target of institutional activism in the next year or so? What about DHG? Here's the list:

CEF Ticker	Institutional Ownership %	16 Institutions' Ownership %
ASG	22.9%	11.7%
DHG	32.0%	17.5%
FGF	36.7%	18.0%
GRX	4.0%	1.7%
HQH	18.3%	3.4%
NFJ	15.3%	5.1%
RTU	20.9%	7.8%
SCD	24.8%	11.3%
SLS	18.4%	7.0%
USA	19.0%	9.8%

Readers are invited to help extend this research to other funds.

Disclaimer: Free advice isn't worth the price, so do your own due diligence.

Disclosure: Long DHG, FGF, HQH, RTU, SCD and SLS.

Comments

[Joe Eqcome:]

Gwailo

Thank you for your invitation to extend your analysis with reference to “activist” investing in CEFs. It’s a great article; interesting question.

I’ve hyperlink the following articles that address the issue on both ends of the spectrum.

The first one is: Activist Arbitrage: A Study of Open-Ending Attempts of Closed-End Funds.” from Duke. finance.wharton.upenn.edu/~itayg/Files/cefactiv...

The authors content that CEF discounts attract activist arbitrageurs, but these discounts shrink in anticipation of an activist arbitrageurs’ attack.

Importantly, the ability of the activist to ultimately close the gap between the price and NAV is the CEF’s governance. While you might be able to “rattle the cage” and get some concessions from current management—like a tender offer at a lower discount, replacing the management of CEF at the board level is a proxy issue and the activist investors should be willing to take this on. The authors go on to observe that the 1992 proxy law reform gave outsiders additional flexibility to wage proxy contests.

The other article is: “The Use of Tender Offers to Address Closed-End Fund Discounts.” www.claymore.com/docs/...

This is a non-academic article that might have some bias as it was written by the folks at Claymore who sponsor CEFs. Their study suggests that while the tendering of shares, as a way to fend off “activists”, might be productive both before and after the tender offer, the median change after one year was a negative 1.5% “returning the fund to where they started.

They go on to conclude: “However, even if effective (the tender offer), it frequently introduces the negative effect of a higher expense ratio and less liquidity. Furthermore, the discount is rarely eliminated and occasionally, it even widens.

So, is following an “activist” CEF investor(s) a smart strategy? If such investors are well-capitalized and willing to take on a proxy fight to remove the present management and liquidate or convert the CEF to an open end fund, the answer may be yes.

If the CEF governance is too onerous, then maybe this is just “greenmail” attempt. At best it’s a short term trade, or, at worst, you’re being played by such activist investors as their exit strategy is based on you bidding up the price of the shares.

Another activist group that's worthy of mention is Horejsi Group with interest in BIF, BTF, DNY where they are actually the managers. The also are involved in a proxy fights with SRO and SRQ.

It’s an interesting topic. Thanks for your thoughts.

Joe Eqcome

Sep 18 11:51 AM

[Joe Eqcome:]

OOOpps,

The hyperlink to the first study was cut off for some reason in my comment above. I think this one might work.

finance.wharton.upenn.edu/~itayg/Files/cefactiv...

If that doesn't work, you can go to my website and look under the tab "Academic Papers" where you can find it.

Sorry for the inconvenience.

Joe Eqcome

Sep 18 11:59 AM

[Gwailo:]

Hi, Joe Eqcome

Thanks for the academic links. You've pulled together a lot of good research on your site. The Wharton study is additional proof that activists tend to target CEFs with large discounts and significant institutional ownership. See their fn. 27: "In a private interview, Phillip Goldstein said that he targets funds with more than 15% institutional ownership." They looked at data from 1988 to 2003: since that time institutions have increased their share of CEF ownership. In addition -- and this is the central point of my article -- about a dozen large hedge-type funds now specialize in CEF investment. They aren't "front-line" activists, but they stand to profit from activism, and I suggest that individuals might gain from following them.

You're being polite in calling the Claymore report on tender offers
"non-academic". (The technical term in Finance theory is "crap.") The Claymore report shows that if you (a) don't count "terminated" funds where tender offers were followed by open-ending or liquidation, (b) don't count the profits made by shareholders who responded to tender offers, and (c) explain away any results that you don't like, you can conclude, inconclusively, that: "Given the results of this study, it is unclear if actions such as tendering shares produce any long-term benefit for shareholders."

Of course, if you were Claymore, you could then propose an in-kind tender for 40% to 45% of the shares of DCS in order to deflect a challenge by Phil Goldstein to your profitable sale of the fund management contract. You could even file a Form DefA 14A on 9/14/09 that says "a tender offer structured in this manner would be in the best interest of all shareholders of the Fund." Considering what fate has in store for hypocrites, Joe, I'm sure you're glad that you're not Claymore.

Keep up the good work. And please do help extend this line of research. Thanks,

'Gwailo

Sep 18 09:56 PM