The red flags for investors in closed-end funds

April 2020 - Joe Bauernfreund

One of the most important starting points in investing is knowing where to look for opportunities, yet what is perhaps more difficult is knowing exactly what characteristics to look out for.

Closed-end investment funds – some of which are also known as investment trusts – are a popular option for investors and the sector has expanded rapidly in recent years. This greater choice is surely good news for investors. But with more choice comes greater responsibility in sifting the good investment from the bad.

It is crucial to be aware of the positive signs that suggest a strong investment opportunity, the red flags that warn of a potentially weaker opportunity, and the steps you can take to identify the two.

Do your research

When looking for red flags, the key to uncovering warning signs involves digging into the detail. Are there any signs of trouble being stored up for the future?

Examining what we call ‘qualitative’ factors, such as the effectiveness and performance of the board, forms part of this process.

“Looking past the marketing spiel and examining the detail of a closed-end fund is a vital habit to adopt.

The devil is in the detail

Looking past the marketing spiel and examining the detail of a closed-end fund is a vital habit to adopt. Checking a closed-end fund’s fact sheet to find out if it is trading at a premium or discount to its net asset value (NAV) is a good starting point.

If it is trading at a discount – where the closed-end fund’s net asset value is higher than the value of its shares – an investor should question what is driving it.

A closed-end fund can trade on a discount for a multitude of reasons. Wide discounts often occur if there is question over the validity of the asset value, poor corporate governance, or where the assets are distressed. Closed-end funds exhibiting these characteristics should be
treated with caution.

Sometimes the market’s perception of the fund fails to keep pace with changes and improvements that have been made. This could result in an anomalous discount and, potentially, a ‘bargain’ price.

This situation can occur even for high-quality closed-end funds. Times change, and a NAV discount can be a good entry point to a fund that has made improvements that aren’t yet recognised in its share price.

What are the other signs to look out for?

A strong board can be a key indicator of a potentially strong closed-end trust. Robust governance structures ensure the trust is always acting in the best interests of you – the shareholders. In the closed-end space this might involve judging the robustness of the investment manager’s philosophy, the strength and independence of the board which provides oversight for the fund, or perhaps the long-term performance.

The board should be fully independent from the investment manager, enabling it to question decision-making and ensure decisions are consistent with shareholder interest.

Ask yourself, does it have a history of standing up for the fund’s shareholders? Or has the board shown an inclination to act in the manager’s best interests rather than those of shareholders?

The voting structure is equally important. Do all shareholders have full voting rights? If not, it could make it more difficult to enact change, and can be a sign that the fund is not open to development. Examining the shareholder base is also crucial – are there large shareholders resistant to change?

A further area of interest is management contracts. Terms which include a punitive termination clause can prove restrictive – there are examples of funds where the termination of the management contract triggers a payment of multiple years of management fees. Clauses such as these can often prove a barrier to a restructuring that may be in the best interests of shareholders.

When it comes to the underlying investments, again looking into the detail is important. You could find the fund does not directly own the assets in which it invests, instead acting as a feeder fund into a master fund run by the investment manager, and that master fund will in turn own the underlying assets. This kind of relationship can sometimes mean the board does not have full control over the underlying assets, in which case the fund’s directors may be powerless to intervene or order a sale of assets– something to be concerned about if performance faltered.

…And a pinch of judgement

Ultimately, you must make an investment based on your own judgement and personal circumstances. Selecting where and with whom to trust your savings can be a difficult decision to make. With some knowledge of the warning signs, an investor can improve their understanding of the risks involved, and hopefully reap long-term gains.

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