Institutional Shareholders New Driving Force for Closed-End Funds
By Cecilia L. Gondor, Executive Vice President, Thomas J. Herzfeld Advisors, Inc.
2014 marks my thirtieth anniversary working with closed-end funds. Much has changed over three decades, but perhaps the most significant change is the shift in shareholder base. Understanding who owns a fund’s shares gives great insight into how those investors are likely to react in various market environments, and, in some cases, may impact a fund’s future course.
Closed-end funds have historically been a product favored by, and marketed to, retail investors who buy with the intention of holding long term. When I started my career in the 1980s, for instance, few institutional investors bothered with this investment vehicle. Thomas J. Herzfeld Advisors, Inc. and our former affiliated broker/dealer were perhaps the only firms specializing in this small niche. As the number of initial public offerings (IPOs) of closed-end funds began to grow in the 1990s, foreign stock funds were popular, giving small investors an opportunity to participate in overseas equities through a New York Stock Exchange-listed investment. Municipal bond funds were also in vogue, with professionally managed portfolios of the securities available not only in national but single-state varieties.
Throughout the 2000s, the types of closed-end fund offerings expanded but there was a common denominator—IPOs stressed an income component, even if the primary investments were to be among equity sectors. Thus, over time, investors began to identify closed-end funds as an income security, and that characterization carried a benefit following the financial crisis. As interest rates fell, the value of many closed-end funds rose, and with the use of leverage, the funds’ ability to pay out attractive distributions to shareholders gained wider acceptance.
The first meaningful shift in closed-end funds’ shareholder base began with institutional value investors focusing on the ability to buy baskets of securities at a discount to net asset value (NAV). Fund valuations tend to be cyclical, alternating between periods when discounts are wide to narrow, and occasionally periods when funds trade at premiums above NAV. Buying when discounts are unusually wide and selling into the narrowing became an established investment technique, and we are proud that our firm is among the pioneers of this strategy.
In some cases, institutional investors did not want to wait for discounts to narrow in reaction to market forces and began to approach fund managements, asking them to initiate discount narrowing action. In those days, dissident pressure had significant limitations, with the balance of power squarely on the funds. A turning point came in 1998 when the SEC made the determination that a fund’s investment advisor could be terminated with a majority vote of shareholders. Prior to that pronouncement, it was unclear whether such a shareholder vote would be binding or regarded as a recommendation to a fund’s board. Emboldened by early success, the number of institutional investors who have taken a dissident stance has increased over the years, as has interest by institutional traders.
A Growing Stake
A separate but equally significant change in closed-end funds’ shareholder base began in the mid-2000s. Sponsors of Unit Investment Trusts (UITs) began offering portfolios of closed-end funds. UITs are fixed, unmanaged portfolios with limited lives, from 15 months to several years, after which the portfolios are liquidated.
We started to notice UIT-declared stakes in closed-end funds in 2005; holdings that represent more than 5% of a fund’s outstanding shares must be reported to the SEC, and these filings have been a good resource for following the increased use of closed-end funds among UITs. By June 2013, UIT-reported closed-end fund holdings totaled approximately $16 billion, and, by our estimation, totaled as much as $20 billion with non-declared holdings taken into account—representing a significant portion of the $250 billion closed-end fund industry. While there has been some reduction in UIT stakes recently, this group remains the single largest category of institutional shareholders of closed-end funds.
In addition to UITs, other types of closed-end fund of funds products have also thrived: ETFs, ETNs, and even open-end mutual funds that hold closed-end funds in their portfolios have been growing in size and popularity.
All of these investment company holders of closed-end funds are not only typically passive shareholders, but are generally limited in how they can vote their shares to what is called “mirror voting.” This means casting ballots in the same proportion as other shareholders, e.g., if 40% of all other shareholders vote in favor of an agenda item and 60% against, the investment company votes 40% of its shares “for” and 60% “against.”
The underlying shareholders of most of these investment company products continue to be primarily retail, with each fund structure offering unique benefits related to professional portfolio selection or management, ease of investment, and liquidity.
Influence of Non-Traditional Investors
As once the closed-end fund industry benefited from its identification as an income product from 2009 through early 2013, it has recently suffered from that association since May of last year. The average discount of all closed-end funds widened abruptly from about -2.5% before the Federal Reserve began its infamous “taper talk” last spring, hinting it would reduce its monthly open-market bond buying quantitative easing program. Average discounts widened to as much as -9.1% by mid-December 2013. There was intense selling pressure on all types of funds, but most heavily on income funds.
This presented an opportunity for another shift in the closed-end fund shareholder base: buying among professional and hedge fund investors who proceeded to acquire tremendously large stakes of the most deeply discounted funds. For example, one hedge fund group purchased more than $800 million of closed-end funds between June 2013 and year-end. The ease with which these investors were able to build their positions was unusual for an industry that typically faces limitations tied to liquidity.
We are quite certain that it will be significantly more difficult for these new players to sell than it was to buy, and their influence may already be keeping discounts wider, as typical discount narrowing in January was muted this year. What is also quite clear is that unlike retail investors who tend to be long-term shareholders, institutional investors intend to take a short-term, opportunistic focus.
Discounts Will Determine How New Drivers Set the Course
So far in 2014, the average discounts of closed-end funds have generally fluctuated within a very narrow band, between -6% and -7%. While that figure currently stands at around -6.6%, the number of funds at particularly wide discounts remains steady and large. More than a quarter of all funds are trading at discounts of wider than 10%, and almost half are at discounts of between 5% and 10%, as shown in the chart below.
Source: Thomas J. Herzfeld Advisors, Inc.
The future behavior of the newest crop of closed-end fund shareholders will hinge on whether or not closed-end income funds come back into vogue or languish at their currently wide discounts. Should share prices rebound and discounts narrow, these investors are apt to sell and chalk up closed-end funds as just another fleeting opportunistic trade. Should discounts continue to linger, however, their voting clout will be made known through increased support of actions taken by the more sophisticated and established groups of dissidents that already target closed-end funds.
As the years have passed, the number of retail investors who remain direct shareholders in closed-end funds has declined along with their influence. It is clear that these shareholders have taken a back seat to the institutional investors now at the wheel.