On the First Trust Value Line 100 ETF Conversion: Advantages and Drawbacks

First Trust Advisors has done it again. Effective June 15, the firm completed the second-ever transition of a closed-end fund into an exchange-traded fund. The First Trust Value Line (closed end) Fund has been reorganized as the First Trust Value Line 100 Exchange-Traded Fund (FVL). FVL was an actively managed fund, but one with a highly quantitative strategy; the new ETF tracks the Value Line 100 Index.

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.

Comments

[Thus spake ...:]

Give me a break!

That all sounds very nice, but the real facts are these:

Doliver showed up with a large position in FVI, which continued to trade at a large discount. First Trust decided to recommend a conversion to an ETF to head off an unannounced, yet perceived threat. A few days later, they added FVD to their conversion list, rather than go to war with Art Lipson who had acquired a large position of that fund at a discount and was rattling his sabre. First Trust neglected to include FVL in the list of conversions, because there were no threats to FVL at that time. Next, they liquidated FVI in order to avoid a proxy fight over its conversion. Lipson supported the FVD conversion and it went through. A few months later, Doliver showed up with a large position in FVL. First Trust then announced that they would convert it into an ETF as well, heading off another perceived threat. Apparently, there was no opposition to the FVL conversion, and it was recently completed.

There are four things that eventually happen when closed-end funds trade at large discounts and sophisticated, large investors get involved: (1) they convert into or merge with open-end funds, (2) they liquidate, (3) they convert to ETF's, or (4) they announce managed distribution policies that involve high payouts and returns of investor's capital.

Certainly someone needs to put a stop this this sort of thing. Otherwise, the large asset management companies will not find it lucrative enough to bring out new closed-end funds and they will die out. Perhaps we need legislation that makes acquiring large positions in discounted closed-end funds illegal.

2007 Jun 19 09:32 PM

[Ralph F:]

"There are four things that eventually happen when closed-end funds trade at large discounts and sophisticated, large investors get involved... Otherwise, the large asset management companies will not find it lucrative enough to bring out new closed-end funds and they will die out."

Why shouldn't they die out? If they trade at discounts to net asset value, they're a lousy deal for the initial investors, and the 4 outcomes you mention are just the market's way of closing the discount.

2007 Jun 20 10:02 AM

[Walter Baer:]

Or a 5th result: the fund sues the investor, as RHR is doing, to avoid outcomes (1) - (4).

2007 Jun 20 03:59 PM