First Trust can also claim responsibility for the first-ever CEF-to-ETF conversion after relaunching its First Trust Value Line Dividend Fund as the First Trust Value Line Dividend Index Fund (FVD), effective December 18, 2006.
“Both funds were unique cases in that they both had historically traded at large discounts to their net asset values (NAVs) despite very attractive share price performance and very solid NAV performance,” says Jeff Margolin, vice president and closed-end fund analyst at First Trust Portfolios, of the decision to convert the closed-end funds into ETFs. “So the funds had solid track records, but they traded at big discounts to NAV because they didn’t have very high yields. Often in the CEF world, if a fund does not have a big yield, it can trade at a discount to NAV.”
Margolin cites three key advantages to the conversions that were considered when making the decisions. Perhaps the most important result that First Trust hoped for in both cases was the elimination of the discounts at which the funds were trading. Closed-end funds have a fixed number of shares, while ETF sponsors can create new shares as new money and investors flow in. This feature is one of the reasons ETFs do not generally have huge discounts or premiums.
According to Mark Hulbert of the Hulbert Financial Digest, immediately before the reorganization was approved in February, FVL was trading at a nearly 8% discount. That discount fell to roughly 3% the day of the vote. As of the first day of trading as an ETF on June 15, the fund’s discount had narrowed to 1.4%. Meanwhile, FVD was trading at a minuscule discount of 0.03% as of June 15, roughly six months after its December 2006 conversion.
The conversions have also lowered expenses, Margolin says. The closed-end funds each had expenses totaling roughly 97 basis points; now that they are ETFs, those expenses are now down to 70 basis points.
Third, both of the funds followed highly quantitative strategies as closed-end funds, which made them uniquely suited to make the transition to index-based ETFs. Margolin points out that FVL invested in the stocks of the Value Line 100 Index using a quantitative methodology, so it was a relatively smooth change.
“Value Line is a ranking system we have a lot of belief in, and it has a track record going back to 1965, so there were really a lot of benefits for shareholders by this conversion,” he says.
One of the drawbacks to the conversion is the potential for a significant loss of assets as some investors take profits when the discount narrows. FVD had assets of $544 million at the time of its conversion to an ETF. As of June 15, it had $276 million, a decline of roughly 50%. Margolin speculates that profit taking by institutional investors and shorter-term investors was likely the main reason for the loss of assets in FVD.
“I think you have to take a long-term view of our funds,” Margolin says. “Despite the fact that we’ve lost assets in FVD, it is still a fund that has a very good track record, both short and long term. And I think over time we’ll be able to grow that fund again.”
FVL has also seen some asset erosion, and Margolin believes more is possible from profit taking by institutional and short-term investors. However, he also believes the fund has a built-in base of investors who are satisfied with the fund’s performance and who will add to their positions over time. In particular, he believes the impressive performance and long track record of the Value Line 100 Index will be a strong selling point for investors and attract further assets.
Despite the fact that First Trust has broken new ground in the world of ETFs, Margolin doesn’t think the floodgates have opened on the conversion of closed-end funds into ETFs and says First Trust has no specific plans to do any more conversions currently. FVL and FVD were unique cases because of their steep discounts and the ease with which their quantitative strategies could be transitioned to index-based strategies.
“I think that generally speaking, when you’re talking about our family of closed end funds and the whole universe of over 650 closed-end funds, I really do think it’s unlikely you’re going to see a wave of closed-end funds converting to an ETF format. There could be a small handful of funds that think about the conversion and then make the conversion. It really takes a fund that has a very quantitative approach that can be matched up against an index,” he says.