POTENTIAL ADVANTAGES OF CLOSED-END FUNDS
Potential Advantages of Investing in the Funds and Closed-End Funds in general.
1. We believe that people who buy our Funds should plan to do so only if they intend to hold them a long time and have the discipline to avoid selling them when the discount from net asset value (NAV) is large. The discount between the price and NAV varies over time, much like the P/E of common equity stocks varies over time. It is best to buy when the discount is large and sell when the discount is small. Sometimes the change in discount is just a result of changes in sentiment about the fund or the market in general or the fund's holdings and sometimes it is a result of actions taken by the fund.
2. We believe, one way for investors to obtain professional investment advice at virtually no cost is to buy closed-end funds at a discount. Every mutual fund has certain fixed and variable expenses that erode its performance. Thus a mutual fund's shares will always under-perform its underlying assets by the cost of operating the fund. However, if you buy a closed-end fund at a discount which is greater than the ratio of the fund’s expense to expected return and only sell when the discount has narrowed, then you will get the same result as the underlying assets. It is our thinking that all mutual funds (closed- and open-end) should logically trade at a discount. But buying closed-end funds at a discount is the primary way you can offset this under-performance and achieve the same performance as the underlying assets. Thus we think our Funds trading at a discount is rational and beneficial to those buying at the current discount.
3. We believe that size matters. Among other things, increasing the size of a fund necessarily reduces the fund’s expense ratio, thus ultimately benefiting stockholders. Therefore, we may conduct "rights offerings" from time to time in order to increase the size of the Funds. In the typical rights offering a fund will issue "rights" to current stockholders permitting them to purchase additional fund shares, usually at a discount to market price. Stockholders who do not exercise their rights may be diluted, unaffected or enriched by the offering (i.e., the net asset value of their shares after the offering may be less, the same as, or more than before the offering, depending upon whether the offering price is less, the same or more than the then NAV). Rights may be transferable, allowing the holder to sell them in the open market to others who may wish to exercise them. When rights offerings are announced, arbitrageurs sometimes sell the fund short, driving the price down with the intention of buying and exercising the rights to cover their short position. This usually widens the discount but is not detrimental to the owners as long as they don’t sell during this period. Since the Funds may conduct rights offerings from time to time, we urge you to buy Fund shares only if you are comfortable knowing there may be rights offerings, and if you are sufficiently disciplined to avoid selling during the periods before and after the offerings. A few months after a rights offering ends, the discount typically returns to the level that reflects investors’ sentiment about the future of that fund without any influence from the rights activity. However, there is no certainty in this occurring.
4. One advantage of investing in closed-end funds is that the investment adviser is under little or no pressure from stockholders to jump on the current hot stock or fad. This is not the case with open-end funds. In a hot market like we saw during the Internet craze of the 90s, undisciplined stockholders often flee mutual funds that are not invested in the hot-stock-du jour. Since fleeing stockholders necessarily reduce the size of an open-end fund, advisers may feel pressure to invest in hot stocks to avoid losing these stockholders (reducing the overall size of the fund). We believe that fad investing usually ends badly.
Closed-end funds don’t face this kind of pressure. So if there is the perception that we are in the wrong sectors or stocks, it is our decision and not one forced on us by fear of losing investors. Also, unlike open-end funds, closed-end funds offer the advantage of not having to sell good stocks during down markets to pay for redemptions and not having to invest cash at the peak of markets because investors are buying more of their fund shares.
5. Closed end funds do not have "distribution fees" (12b-1 fees) because they are not continually marketing shares. "12b-1 fees" get their name from the SEC rule that authorizes their payment. The rule permits a fund to pay distribution fees out of fund assets only if the fund has adopted a plan (i.e., a 12b-1 plan) authorizing payment. "Distribution fees" include fees paid for marketing and selling fund shares, such as compensating brokers and others who sell fund shares, and paying for advertising, the printing and mailing of prospectuses to new investors, and the printing and mailing of sales literature. 12b-1 fees are present in many open-end funds but do not occur in closed-end funds. There may tend to be a similar cost in closed-end funds as a result of a rights offering, but this cost will only be incurred when the Funds' Board or stockholders conclude the that the benefits outweigh those costs. Further, it will not be a continuous drag on the Fund and will only occur when the Board determines it will allow the Fund to buy investments at an attractive price.
6. Because closed-end funds have a fixed capital base, they can issue preferred stock or, in the case of the Funds, auction market preferred stock (AMPS), a perpetual and cost effective form of leverage. Open-end funds are not able to do this because they have to respond to redemption demands.
7. Similarly, because open-end funds have to be able to respond to redemption demands, they have limitations on the percent of illiquid stocks they can own. Closed-end funds do not have this limitation.
8. Closed-end investors often have a chance to buy at a discount (sometimes substantial) and thus will get a better return than in an open-end fund (where there is no discount) because any dividends or gains will be a ratio of the price paid rather than the NAV. If a fund's shares are bought at a discount, the return for the stockholder can be greater than that of the fund itself and, if bought at a sufficient discount, will provide the same or greater return than the underlying assets. There is also a chance of a narrowing of the discount which results in a “double-dip”, that is, the return earned by the fund and the price improvement from the narrowing of the discount.
9. Another reason it is often important to buy at a discount is that the fund may have an embedded tax liability on both the current year's realized gains and all of its unrealized gains. In these cases, the NAV of a fund (whether closed-end or open-end) is overstated by the amount of the unrecorded tax liability on these gains. Again, the only way to offset this unrecorded tax liability is to buy at a discount, which can only be done with closed-end funds.