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Closed-End Funds: Fact or Fiction? – Part 2

03/07/2013

Part 1 of our special two-part series presented common misconceptions about investing in closed-end funds. In Part 2, we dig a little deeper, testing your knowledge about some of the choices frequently facing closed-end fund shareholders that may be unfamiliar, even confusing.

FACT or FICTION? (Click on the statement to scroll down for the answer.)

1)     For dividends paid in stock or cash, it is always best to choose cash.

2)     Never ignore a closed-end fund tender offer.

3)     A known dissident investor has purchased a fund I own; I’m sure to make money on the holding now.

4)     There is no impact on my holding in a closed-end fund if I don’t participate in its rights offering.

5)     There is an easier way to take advantage of, or not be disadvantaged by, various types of special closed-end fund opportunities.

1)   FICTION: Some closed-end funds give shareholders the option to receive stock or cash for particular distributions. Such a choice is most common for large, annual year-end distributions made by funds to fulfill IRS pass-through requirements; however, a few funds do this for all of their payouts. The terms of each offer differ, so it is important to read the fine print. Some funds simply reinvest the shares at the prevailing market price, while others issue new shares at the market price or at NAV (net asset value).

When given the option to receive stock or cash, stock is almost always the better choice. If the fund is trading at a discount, the new shares are typically purchased in the open market or, in some cases, issued at market price. If the shares are trading at a premium, new shares are usually issued at the higher of NAV or 95% of market price—both of which represent a discount to the market price.

One caveat: Check with your brokerage firm to find out if you are enrolled in its reinvestment program. Depending on the firm’s policies, your account may be coded to reinvest your distribution by purchasing shares in the open market at the prevailing market price.

2)   FACT: In a closed-end fund tender offer, shareholders are given a limited opportunity to sell a portion of their holding back to the fund at a price at, or very close to, NAV. In almost all cases, the tender price is higher than the market price, and because of the way investors tend to behave, there is often an opportunity to buy back the position at a lower price after the expiration date of the offer. Here’s why:

Traders tend to be attracted to a fund conducting a tender, buying shares in order to participate in the offer. These short-term investors typically sell any excess shares that are not accepted for tender after the offer expires, putting pressure on the share price. This is what gives long-term shareholders the opportunity to replace their tendered shares with shares at a lower cost.

It is important to look closely at the terms of the tender offer. In a few instances, the tender price may be at a meaningful discount and not particularly attractive; we’ve seen them priced at as much as an 8% discount to NAV. In even rarer instances, the tender price is less attractive than the market price. Fixed-price tenders are vulnerable to this potential dilemma. So are interval funds that prescribe tenders annually or semi-annually. Holding them on schedule, even when shares may be trading at premiums to NAV, results in a tender price that is lower than what the investor would get if the shares were sold in the open market.

In another infrequent scenario, payment for tendered shares may be made in shares of the underlying portfolio’s holdings. This is called an “in-kind” tender offer. Larger investors may be equipped to handle receiving (and then incurring the cost of selling) a dozen or more securities in exchange for their closed-end fund shares. Some funds include provisions to pay their investors with a very small shareholding in cash. Mid-sized shareholders need to evaluate if the deal will be a good one for them or a potentially costly headache.

3)     FICTION: In a closed-end fund rights offering, existing shareholders are issued rights that can be exchanged in specified ratios to purchase additional common shares at a specified subscription price, indicated by the terms of the offer. The subscription price may be a fixed price but more often it is a formula representing a discount to the fund’s NAV and/or market price. Rights may be transferable, which means they are listed on a stock exchange and can be sold; or non-transferable, meaning only the shareholder who received them can exercise them and if that doesn’t occur, they expire worthless.

If you don’t participate in a rights offering with a subscription price below NAV, you suffer dilution. This means the NAV after the offering is lower than it was before, which makes sense because new shares were added to the pool at a lower price. The opposite occurs if you don’t participate in a rights offering with a subscription price above NAV. The NAV is enhanced because adding new shares at the higher price is accretive to NAV. Although you enjoy this benefit even if you don’t participate, it doesn’t mean you should necessarily pass up a rights offering priced above NAV. The deal may still allow you the rare opportunity to buy a routinely premium-priced fund at a lower cost.

Keep in mind, a second kind of dilution occurs simply by having more outstanding shares after the offering is over, and your percentage holding in the fund has been reduced.

4)   FICTION: Often the declaration of a large holding by a known dissident does result in an increased share price as tag-along investors buy in too, seeking to ride on the dissident’s coattails. However, dissident activity is costly and full of uncertainty.

Several institutional investors seek to buy closed-end funds at persistent, wide discounts. If the discount does not narrow on its own, they then contact fund management, requesting that action be taken to narrow the discount. Common discount-narrowing strategies include the fund buying back shares in the open market; tender offers; instituting a managed payout policy; modifying the fund’s investment focus; or adopting a “discount management plan” that includes several of these strategies. In extreme cases, the fund may decide to convert to an open-end fund, which would allow for daily redemptions at NAV, or management may opt to liquidate the fund.

While some of these actions may result in a higher share price, the actual objective is a price closer to NAV – and that is a moving target. Discount remedies may take several months, even years, depending on the action. Open-ending and liquidation generally require shareholder approval, and getting the required vote may prove difficult or, in some cases, impossible. Even if the discount disappears and the NAV declines in the interim, the share price may be lower than your purchase price.

5)   FACT: Closed-end funds require attention, especially when corporate actions occur. Consult your financial advisor to assess how your interests may be impacted by a particular event; he or she may point out pros and cons that are not immediately obvious. Another option is to consider a “fund of closed-end funds” and leave the selection of funds to investment professionals. The Virtus Herzfeld Fund, subadvised by Thomas J. Herzfeld Advisors, Inc., participates in special situations like the ones described above as part of its investment strategy.

IMPORTANT RISK CONSIDERATIONS:

Closed-end funds may trade at a discount from their net asset values, which may affect whether the fund will realize gains or losses. They may also employ leverage, which may increase volatility. The market price of equity securities may be affected by financial market, industry, or issuer specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk. Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a security may fail to make payments in a timely manner. Values of debt securities may rise and fall in response to changes in interest rates. This risk may be enhanced with longer term maturities. Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk. U.S. government securities may be subject to price fluctuations. An agency may default on an obligation not backed by the United States. Any guarantee on U.S. government securities does not apply to the value of the fund's shares. Because the fund can invest in other funds, it indirectly bears its proportionate share of the operating expenses and management fees of the underlying fund(s). For additional information on these and other risk considerations, please see the fund's prospectus.

Investors should carefully consider the investment objectives, risks, charges and expenses of any Virtus Mutual Fund before investing. The prospectus and summary prospectus contains this and other information about the fund. Please contact your financial representative, call 1-800- 243-4361 or visit www.virtus.com to obtain a current prospectus and/or summary prospectus. You should read the prospectus and/or summary prospectus carefully before you invest or send money.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.