Closed-end-fund IPOs: Is the door shutting?

Jul 25, 2005 @ 12:01 am

By Dan Jamieson

IRVINE, Calif. - The issuance of new closed-end funds has begun to slow amid concerns about slackening performance, market saturation and possible regulatory attention.

Over the first six months of the year, brokerage firms raised $14 billion in such initial public offerings, according to the Closed-End Fund Association Inc. in Kansas City, Mo. That pace is off from the $16.4 billion raised in the first half of 2003 and the $15.3 billion in the first six months of 2004.

For all of 2003, investors poured a record $28.3 billion into closed-end-fund IPOs, then followed up with another $23.1 billion in 2004, according to the association.

"Closed-end funds have peaked," said Mariana Bush, a Washington-based analyst of closed-end and exchange traded funds with Wachovia Securities LLC of Richmond, Va. "Six months ago, we saw seven to nine issues a month. Now that's down to two or three."

Offering sizes are down, as well, Ms. Bush added. A year ago, $1 billion funds were not uncommon, but now one-half that size is a successful offering, she said.

The post-crash environment drove a "big boom" in new issues, said Brian Smith, a spokesman for the Closed-End Fund Association.

Rising interest rates have hurt performance in the closed-end market, which is dominated by fixed-income funds. Plus the market has been saturated with a variety of products, Ms. Bush said.

'Horrible buys'

Critics have long derided the idea of buying IPOs of closed-end funds.

Recent trading history shows the landscape littered with issues that have fallen 20% to 30% from their offering price after underwriting support is pulled, typically 45 days after the offer.

Due to the 4% to 5% underwriting fee that comes out of net assets, new issues come out at premiums. The issuing process takes most buyers out of the market, so subsequent selling tends to create discounts to net asset value.

"They're horrible buys" on the offering, said George Karpus, president and CEO of Karpus Investment Management in Pittsford, N.Y. "Very few ever go to premiums" in the months after underwriting support has been withdrawn.

Mr. Karpus manages about $1 billion for wealthy investors, about $700 million of which is in seasoned closed-end funds.

Mr. Smith said that investors should use "additional judgment" in buying new issues. With the help of an adviser, "people need to understand what they're buying and how it fits in their asset allocation plan," he said.

Meanwhile, the Securities and Exchange Commission apparently is no longer allowing new closed-end funds to pay out regular distributions that include a return of capital. These "managed-distribution plans" have been used to help narrow discounts, but because they require payouts higher than earnings, they require the SEC's blessing.

The commission hasn't been granting exemptive relief for some months, Mr. Smith said. Some observers say that the SEC might be concerned that investors could be misled by the high post-IPO yields on some funds.

An SEC spokesman would not comment on the existence of any such policy, but Brian Bullard, chief accountant of its division of investment management, has been quoted as saying that some mutual fund companies have not been submitting along with their dividend payments the so-called 19a notices, which let shareholders know whether the cash is from realized gains or return of capital.

The agency has had the most trouble with closed-end funds, as many have stable-dividend plans, he reportedly said, and funds that are returning capital "don't have enough income or gains" to satisfy their dividend.

Mr. Karpus, however, defends managed-distribution plans. "The funds that have the payout policies narrow their discounts," he said. "It's been good for shareholders." Mr. Karpus added that when it comes to narrowing discounts, high payouts are more effective than share buybacks.

Brokers uneasy

Individual brokers are some of the fiercest critics of new closed-end funds.

They wonder why, in an age when they're scrutinized for selling annuities and mutual fund B shares, firms have continued to come out with billions of dollars in closed-end-fund IPOs that often end up falling 10% or more from the offering price.

"I quizzed our compliance auditor about that," said a Merrill Lynch & Co. Inc. broker in the Southwest, who asked not to be identified. "She didn't have an answer." This rep said that New York-based Merrill's compliance department routinely looks at the fees clients pay in the firm's fee-based brokerage account, but the costs paid by buyers of new closed-end issues don't seem to get the same scrutiny.

A Merrill spokeswoman did not return a phone call seeking comment.

"The underwriting costs and markups [on closed-end funds] are much higher than they ought to be," said a Wachovia broker in the Northwest, who asked not to be identified. "You pay 5% for what should cost 1%."

"I'd guess it's just a matter of time" before closed-end funds draw regulatory attention, said Lisa Roth, a San Diego compliance consultant. Washington-based NASD has warned member brokerage firms about sales of a number of non-conventional investments, she said.

"Regulators haven't caught them yet," said a registered representative in the Southwest with Morgan Stanley of New York, requesting anonymity.

An SEC spokesman said that he is not aware of any enhanced-disclosure proposals for closed-end funds. NASD did not return a call seeking comment.

The Morgan Stanley broker said that one reason for selling new closed-end funds is that sales of other products have been restricted so much. The Wachovia rep said that selling the deals also serves as an "admission ticket to hot IPOs" of stocks, because syndicate departments allot the scarcer issues based on past sales of all deals.

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