The Globe and Mail, Report on Business
Published October 31, 2009

When you're trick or treating, keep an eye out for mutual funds dressed up as closed-end funds.

The latest innovation to take hold in the Canadian wealth management industry is “closed-until-open” funds. There has been a wave of new offerings that start out as closed-end funds, but promise to convert into mutual funds (open-ended) after one or two years.

Before looking at the merits of this trend, it's worth reviewing what a closed-end fund is.

Essentially it's a pool of capital that's sold to the public through a formal issue process and then closed to new investment after that. Units trade on the stock exchange, which means that for every seller there must be a buyer.

A key advantage of closed-end funds is that they let the investment managers take a longer-term view, knowing that the assets won't be subject to redemptions. This allows them to invest in securities that can't easily be liquidated such as private companies, infrastructure projects and real estate. It also allows them to use leverage and pursue more exotic derivative strategies.

Closed-end funds generally have lower ongoing management fees than other investment products, but there are tradeoffs. The biggest one is the upfront cost. The initial buyers pay for bringing a fund to market, so after all legal, regulatory, underwriting and marketing costs, as well as sales commissions, only 93 cents of every dollar is available for investment.

The other downside is that liquidity is unpredictable and also comes with a cost – explicitly through a commission and implicitly through a discounted price to net asset value (which is typically the case).

The key takeaway here is that closed-end funds are specialized vehicles designed to fill particular niches. Unfortunately, they have evolved from being permanent pools of capital aimed at non-benchmark investments to front-end load mutual funds in costume. They now have trailer fees, redemption features and are even reopened to new investors from time to time.

The current closed-until-open versions are little more than launching pads for new mutual funds and exchange-traded funds – a way to quickly bring a hot theme or celebrity manager to market. They simply transfer the cost from the fund company to the unitholder.

While the conversion is presented as a selling feature, it effectively destroys the economics for an initial purchaser. To buy an initial public offering (IPO), you need to be convinced it is so unique that it will beat the alternatives by 7 per cent over the next one or two years (to offset the IPO costs) and won't be available at a discount a few weeks after issue.

Many of the new offerings have half a warrant attached, which entitles holders to purchase more units at the same price at a future date. The warrants are also being held out as a key attribute, but there is no free lunch here. If the warrant is in the money and is worth something, then the price of the fund will reflect the future dilution (i.e. trade lower). In that case, unitholders are forced to protect themselves from that dilution by either selling the warrants, or coming up with more money and exercising them.

So while there is no value being created for the investor, the warrants are an attractive feature for the issuer, who is guaranteed to have 50 per cent more assets flow into the fund if the price rises (based on a half warrant).

Compared with the mundane world of mutual funds, closed-end funds are like the Wild West. That may sound a touch cynical, and self serving, but I have my reasons for saying it.

First and foremost, discussions about closed-end funds always have a “squirm factor.” I can't find an investment professional who says the initial buyer is getting a good deal.

Second, besides the issuers, there are others riding on the back of those IPO buyers. Hedge funds (and other traders) have strategies in which they buy units at a discount, hedge their market exposure, add some leverage, and make a nice profit when they unwind the trade on the redemption date. To me, there is something wrong with a product on which professionals can repeatedly and systematically take advantage of the amateur.

And I say wild because we get to witness some corporate intrigue on occasion. This year the unitholders of the Citadel funds found themselves in the middle of a courtroom battle over management of the funds. As it played out, they were no doubt left wondering who was managing their money and how distracted they were.

Also this year, the unitholders of the Sentry Select Diversified Income Fund were asked to forgive a loan to the issuer (Sentry Select) as part of a closed-to-open conversion. While a vigorous debate revolved around elements of the restructuring, a bigger question was overlooked. Did the experienced and talented Sandy McIntryre, manager of the fund, really want a prime-rate loan to his own company to be his largest holding?

For these reasons, and the overhyped selling features discussed earlier, investors need to clearly understand why they are buying a new closed-end fund. If there aren't compelling reasons, then it's best to let someone else be the first to reach for the candy. Hang back and go for the raisins instead.