FMD Capital Management

Closed-End Fund IPO Participant? Don’t Drink The Kool-Aid

Written by Michael Fabian, September 10th, 2013

The lengthy, arduous task of launching a new closed-end fund (CEF), only to have it begin trading in one of the toughest interest rate environments in years, simply leaves IPO participants in a lurch. It causes the fund sponsor to appear foolish at best, and shareholders wondering what could have gone so wrong. This very scenario of a poorly timed offering, alongside poor investor confidence, represents the outcome of two sizable funds that just recently came to market.

For those that are unfamiliar with the process, every CEF goes through an IPO process. Similar to an individual stock, investment bankers work with the fund’s sponsor, investment advisor and board of directors to establish the size of the offering, prospectus detail, investment strategy and pitch material. Then those same bankers educate their broker underlings on the intricacies of marketing the fund to clients, who then thumb through their Rolodex and “dial for dollars” in an attempt to push the product and fill the bank’s quota. A process which can involve much more detail than outlined, but with the resulting aftermath all the same.

Traditionally offered to affluent clients of wire houses, these investors can often times suffer from misinformation or even strong arm marketing tactics. Many savvy, self-directed investors could proclaim these victims got exactly what they deserved for not doing their own due diligence. However, most would also agree that Wall Street has a way of assimilating unsuspecting investors to a “limited” offering such as a new CEF, especially smaller households that feel privileged to merely hold an account with the institution.

It makes me cringe whenever I hear that an investor was unknowingly sold a fund, or had limited knowledge of what risks lie ahead after the shares begins trading. Furthermore, it’s even common practice for investors to not even be made aware of the roughly 5% load that will come right off the top of the beginning NAV value. Although unfortunate, it remains an inconvenient truth that for an IPO to take place, a group of investors must raise their hands to get the fund off the ground.

I suppose the moral of the story, or the glass half-full perspective, is that educated investors can profit from these mishaps. In addition, I will state that not all IPOs turn out that way, only most of them.

So how can you use this information to your advantage in the future?

First off, if a broker calls to pitch you the next amazing CEF buying opportunity, simply listen to the entire explanation start-to-finish. Ask as many questions as you can about the strategy and beginning allocations, scratch down the name, ticker symbol and expected IPO date. Then politely thank him, and turn down any participation in the offering.

Secondarily, and this can apply to all investors, add the CEF to your watch list and simply pay close attention to the first 3-6 months of trading activity. More specifically though, follow the correlation of the funds market price relative to its NAV. This can be done using publicly available information reported on the fund sponsor’s website or services such as cefconnect.com. Attempt to discern how the fund’s NAV trades in relation to the asset class the fund utilizes, that way you can get a better sense of the manager’s strategy and appetite for risk in the prevailing market environment. Once the fund’s load has been burned off, or weak handed IPO participants jump ship after the initial 29 day underwriter support period, you may be able to uncover a bargain.

The two funds that I have on my watch list that recently started trading in the May-June timeframe are the Guggenheim Credit Allocation Fund (GGM) and the Flaherty and Crumrine Dynamic Preferred and Income Fund (DFP). Both funds have posted very poor market price performance vs. their respective NAV performance in their first few months of operation. In my opinion, a fund starting with 100% cash, thereby creating a portfolio from scratch in the current market environment, has many advantages over a well established portfolio. This is because portfolio managers have the unique ability to tilt exposure toward securities that present the best risk-to-reward for price appreciation without having to sell down existing holdings.

It makes for the perfect confluence of individual investor fear and institutional investor confidence, creating the perfect advantage. Although I don’t have any positions established in either of the aforementioned funds for clients in our CEF portfolio, I’m watching closely for signs of market price stabilization, or pure relative valuation. There is no perfect formula for when a CEF becomes attractive, but you do stand the best chances for an attractive cost basis using patience. Spread your purchases out over time, and don’t become over exposed to just one or two funds. I recommend that both novice and experienced CEF investors follow new IPOs closely to take advantage of price dislocations as they present themselves.