Choppy market seen hurting closed-end funds

IRVINE, Calif. — Market turmoil could create some pretty unhappy closed-end-fund investors and put a damper on the closed-end-fund-underwriting business. At the same time, professional closed-end-fund investors said that they are still buying their favorite issues, which now trade near historically large discounts to net asset value. Prices on closed-end funds are set in the market, not at NAV as is the case with open-end funds. The market’s sell-off this month provided a once-in-a-lifetime buying opportunity in closed-end funds, market observers said. Aug. 16 “was the best buying opportunity I’ve seen in my life,” said George Karpus, president of Karpus Investment Management of Pittsford, N.Y., who has been in the industry for 38 years. “Bond funds went to their widest discounts in history,” said Mr. Karpus, who manages $1.5 billion, with about $1 billion of that in closed-end funds. Double-digit discounts Bond funds “got to high-double-digit discounts,” said Phillip Goldstein, founder of Bulldog Investors, a Saddle Brook, N.J.-based hedge fund manager. “And junk [bond] funds were at 20% discounts,” he said. Although the market has since bounced back, Mr. Goldstein and other professional closed-end-fund investors still see a buying opportunity based on the wide discounts. If the Federal Reserve Board cuts interest rates, leveraged funds could increase their dividends, said Michael Jones, chief investment officer at Wachovia Securities LLC in Richmond, Va. And higher volatility creates higher options premiums, which should help option-writing funds, he said, though he added that the market’s decline may not be over. The selling pressure on closed-end funds may have been driven in part by hedge funds, Mr. Karpus said. “With the liquidity crunch, they had to sell anything they could. There were blocks [of closed-end-fund shares] coming out,” Mr. Karpus said. “Normally, we don’t see that,” he said. “Usually, it’s retail” trading activity. Retail investors may not be done selling. Many of the sharpest drops hit newer funds that came out in past year or two, said Thomas J. Herzfeld, president of Thomas J. Herzfeld Advisors Inc. in Miami. “Most investors thought they bought something relatively safe, with an 8%, 9% or 10% yield,” he said. But many of the high yields are from a return of capital, and many are leveraged, Mr. Herzfeld said. Some funds return capital to investors as part of an income distribution strategy designed to minimize discounts. “People confuse return of capital with income,” Mr. Herzfeld said. “That’s the way they were sold to the public.” Some of these high-yielding funds recently traded at premiums to NAV, Mr. Herzfeld said. “They were really overpriced based on a misrepresentation of what the yield was,” he said. Of 30 new issues this year, all are down from their offering prices, Mr. Herzfeld said. Wall Street has sold a boatload of income-oriented products in the past several years. Year-to-date through last month, $25.9 billion was raised in 30 new issues, which includes equity funds, according to the Closed-End Fund Association Inc. in Kansas City, Mo. The prior record was set in 2003 when $28.3 billion of new closed-end funds were sold during the full year. Sponsors have been raising $20 billion-plus a year since the market recovery in 2003, except for last year, when volume slowed to $10.6 billion. More selling pressure could come later this year as unsophisticated investors who were attracted to the high yields see losses and get nervous. “Investors are going to get hurt again at the end of the year because of tremendous tax selling” of the newer funds, Mr. Herzfeld said. The recent market turmoil may also put a damper on the new-issue business. “People have been burned if they owned a lot” of newer closed-end funds, Mr. Karpus said. “Brokers won’t be able to sell them” after the recent dip, he said. With existing funds selling at larger discounts, it will be hard for underwriters to come out with new products, Mr. Goldstein said.