Dennis Matecun: Enjoyed your article on closed end funds, but think you made an error in calculating discounts. You wrote: “If GM is worth $50 a share, wouldn’t GM’s performance-minus-1%-per-year be worth only $45, if that?” But $50 minus 1% would be $49.50 per share, yes?
☞ No. I knew I should have written this more clearly. Sorry. Here’s what I meant (and even if you knew what I meant, keep reading, because there’s something that might actually make you some money, as you get into this):
Say you knew that GM, between its dividend and the appreciation of its stock, would average a 9% return over the next 20 years. Heck of a lot better than a 5% savings account! So maybe you go ahead and pay $50 a share.
(None of this has anything to do with GM, I am just using it as an example.)
Now along comes a closed-end fund that owns, let’s say, nothing but GM. (Of course, it would own lots of other stocks as well, but I’m trying to keep this simple.)
For its management, it charges a 1% annual fee. Some closed-ends charge less, some more. The site I suggested Monday — http://www.cefa.com/celeadrsdis.htm (at the suggestion of the estimable Joe Cherner, by the way, which I forget to mention) – will show you what different closed-end funds charge.
So now, the GM shares you paid $50 for that will enrich you at the rate of 9% a year can enrich you, instead, within the closed-end fund, at the rate of 8% a year. Namely, GM’s 9% less 1% in fund fees.
My point was: if you’d pay $50 for a 9% return, how much would you pay for an 8% return? Maybe you’d be willing to pay only eight-ninths as much — $45, if that.
The overall point was: closed-end funds should generally sell at a discount to their net asset value, because they are siphoning off their management fee from the return you could get if you owned the underlying stocks directly.
But should these funds be selling at 30% discounts, as some of them are? Or even a 45% discount, as in the case today of the meVC Draper Fisher Jurvetson Fund I (symbol: MVC, traded on the New York Stock Exchange).
Some of them probably should, but there are some interesting factors to consider here.
First, according to closed-end guru Thomas J. Herzfeld, who has been plying these waters a long time, tax-selling frequently drives up the discounts in closed-end share prices this time of year by 5% or 6%, with a snap back in January. A fund that sells at a 15% discount all year might dip to a 20% discount under the pressure of tax selling – and then fairly quickly return to a 15% discount.
Second, if people get scared and want out of the market, because it seems to be tanking, they may sell regardless of the discount, driving it down further.
Third, some fund managers defy the odds and manage pretty consistently to do even worse than average in picking stocks, so that far from adding value that might be enough to justify their fees (in which case a discount would not be rational), they may subtract value by their stock-picking exploits. Such a manager would deserve a very hefty discount – part to compensate for the drag of the fees, and part for the drag on performance.
But 45%? I bought some MVC today at 10¼ because it looks as if it could be an interesting speculation. Basically, it’s a venture capital fund that started moments ago — March 31 — just as the dot-coms were about to collapse. So far, it has invested 38% of the capital it raised, with the balance — $11.72 per share – remaining in cash.
So the good news is that for $10.25, I got $11.72 in cash, plus my tiny proportional stake in 18 private investments the fund has made so far, which it values at a further $7.18 a share. (The fund says the investments are valued conservatively, but who knows what they’re worth? Only time will tell.)
The bad news is that MVC could quickly invest its remaining cash, and that all these deals could then go to hell in a hand basket. If AT&T can fall by two-thirds in a few months, imagine what a basket of illiquid little start-ups can do!
The further bad news is that, because this is a venture capital fund, it charges the normal VERY HIGH fees – 2.5% a year, plus a 20% share in of any gains it is able to make. (Some venture managers charge “2 plus 20,” some, like this one, “2½ plus 20.”)
I am loath to pay high fees and would not have bought into this fund at the IPO eight months ago at 100 cents on the dollar. But to buy it at 55 cents on the dollar improves the odds – especially now that we’ve gone from a seller’s market, when any 18-year-old with an idea could command a $100 million valuation, to a buyer’s market, where even the best ventures have to cut attractive deals to stay afloat. Cash is king, and my new fund has $11.72 of it per share.
MVC is a special case, and may turn out to be nothing more than my latest folly. Many of the other closed-ends you’ll find selling at the steepest discounts are “country funds,” like the Morgan Stanley India Fund, at a 31% discount to Net Asset Value. These entail their own extra currency risk. India might do well, and the stocks Morgan Stanley chooses for this fund might do even better. But if the rupee loses ground to the dollar, it will be a drag on your investment. Then again, the dollar might weaken or Morgan Stanley might decide to narrow the fund’s discount by using the fund’s own cash to purchase its own shares on the open market. Or it could narrow with no help from Morgan Stanley, once tax-selling season is over, or if India ever returns to fund fashion.
Have a good weekend. And remember:
Quote of the Day
It's unbelievable what happened, said Jack Brod, who has operated Empire Diamond and Gold Co. in New York's Empire State building for over 50 years. When gold was over $700 an ounce and silver over $40 everybody wanted to buy it. Today nobody does.~August 12, 1981 Deseret News
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