Joe Eqcome's  Instablog

Adams Express Company (ADX) is a closed-end fund (CEF) that has traded at a persistent discount to its NAV. (For background on the case, see the previous report dated 3/2/09 entitled: “The Case for Tender, Liquidation or Conversion of ADX”.)

The unfortunate aspect of ADX’s persistent discount is the managers of this internally managed CEF have done a reasonably good job of meeting its benchmark returns.

So, this article is not an attack on the management’s investment prowess. It is more of a commentary on two issues: 1) inaction on the part of the independent directors in the face of viable alternatives to maximize shareholders’ value; 2) the possibility that a closed-end fund (CEF) may be a sub-optimal vehicle for ADX.

Why ADX Converting to an ETF is a Win/Win Situation: Simplify put, an ETF is an open-end investment company that is actively traded throughout the day on major stock exchanges; much like a stock of a publicly-traded company, ex., IBM. The important difference between a CEF and an ETF is that an ETF trades at vastly narrower discounts to its NAV—the objective is to trade at par. (I will spare readers the mechanics of this task.)

Emergence of Actively Managed ETFs: While ETFs have historically been designed to track rule-based indices (SPDR S&P 500 ETF: SPY), early last year the SEC approved the launch of actively managed ETFs (“AcETFs”). Invesco PowerShares, Inc. has been one of the most active having launched four active managed ETFs. There are a number of other advisors that have launched AcETFs: Grail Advisors, LLC, American Beacon Advisors and State Street Corp, to name a few.

Here are the reasons why converting ADX to an AcETF makes sense:

1.   The board of ADX will be creating $165 shareholders’ value as the discount is eliminated. This is the equivalent of $2.00 a share, or an immediate return to shareholders of 20% on current share price.

2.   ADX would not be liquidated. It would continue as a “going concern.” Management would remain in-place and continue to operate the company with respect to its portfolio objectives.

3.   ADX would also get a “first mover” advantage. AcETFs have gotten off to a slow start. Many of the new AcETFs have been started from scratch. The average new AcETF has less than $10 million in net assets. By ADX converting to an AcETF, with net assets of $1.1 billion, it would be the “800 pound gorilla” in this space. It would preempt others from angling for that actively managed ETF large cap niche.

4.   ADX’s expense ratio (0.48%) is significantly below that of the other actively managed ETFs (0.70%), so it would have a significant marketing advantage.

Follow the Yellow Brick Road: There is precedence for a CEF conversion into an ETF. The Claymore/Raymond James SB-1 Equity Fund (RYJ) was a CEF. It had a provision in its by-laws to seek shareholders’ approval to convert the fund to an open-end investment company (ETF or mutual fund) if the common shares traded at a 10% or greater discount from its net asset value for 75 consecutive trading days.

On May 29, 2008, RYJ’s Board of Trustees approved the conversion and shareholders subsequently voted in favor. September 4, 2008, RYJ began trading as Claymore/Raymond James SB-1 Equity ETF (RYJ). The merger costs recorded at the end of FY 2008 was less than 0.2% of NAV.

RYJ’s discount narrowed from 11.1% at the end of fiscal year (Aug) 2007 to 0.5% at the end of fiscal year 2008 in anticipation of the conversion to an ETF. As of the end of trading 11/10/09 the shares were selling at $15.19 versus an NAV of $15.23—a discount of 0.26%.

The graph below illustrates the narrowing of RYJ’s discount post the board’s May ‘08 announcement of approval for conversion. This is in contrast to the widening of the discount for the Eqcome CEF Index representing the CEF market segment. Disadvantages: There are few disadvantages from the point of view of the ADX shareholders.

Currently, as a CEF, ADX’s management has a fixed pool of assets that only vary with the price of the underlying assets. As an ETF, ADX would be subject to net asset levels rising or falling subject to the ebb and flow of “subscription” and “redemptions” similar to that of a mutual fund. The difference being, in the case of an ETF, is that it occurs continuously throughout the day. While for a mutual fund it only occurs at the end of a trading day.

This feature could actually end up being a positive for the management of ADX. It could significantly increase its management fees through the attraction of additional capital through superior investment performance. If management can’t perform, then assets will dissipate.

Alternative Means of Maximizing Shareholders’ Value: Right now the management and the board of ADX have “no dog in the fight” with regards to reducing the discount. Management fees are paid in cash on a percentage of net assets; there is little management insider buying of the board and management of the shares.

Exercising Shareholders’ Rights: It is only fair for shareholders to insist on a clause in ADX’s by-laws similar to that of RYJ: that if the discount persists at a certain level, say 10% or greater, shareholders should vote to convert to an actively managed ETF. Another alternative would be a “like-kind tender” of its shares. The last time ADX’s discount was below 10% at month’s end was the same year that “Seabiscuit” was a hit movie (2003). This is unacceptable.

Shareholders need to put a fire under the independent directors. In the final analysis what is being proposed is a better wrapper for ADX. By converting to an AcETF, the company remains fundamentally in tact and the shareholders are able to realize a share price valuation closer to NAV.

If your objective is speed, you’d consider using a jet over a biplane? In the case of ADX shareholders, their objective is maximizing value both near-term and long-term.

Joe Eqcome (Disclosure: Long ADX)