I’m writing as an individual investor who has invested in closed-end funds for more than a quarter century.  During this time, I have owned shares in several dozen CEFs, most for at least five years and a healthy percentage for at least 10 years.  Accordingly, I’m writing as somebody who is experienced in the sector and who invests with a long-term horizon.

Using Bloomberg data, at June 30, 2020 (factoring in all of Q2’s spectacular market recovery), I count 493 closed-end funds with a cumulative $211 bn in market capitalization.  420 of these funds (85%) traded at discounts to net asset value.  More important, $86 bn of the market cap (more than 40%) traded at discounts exceeding 10% and averaging 14.09%.

These funds are predominantly held by individual, or “retail,” investors.  A consequence of these statistics is that investors are painfully enduring $17 bn in discounts, $12 bn of which applies to funds with discounts exceeding 10%.  Again, it is predominantly small “retail” investors who are suffering these discounts to the fair, or net asset, value of their fund holdings – many, many billions in discounts.
 
In contrast, it’s not unreasonable for an investor to expect a fund to trade at or near the full value of its assets.  This is particularly true for funds whose strategies focus on public instruments with transparent market prices and reliable trading liquidity during normal market conditions, characteristics that I estimate apply to at least 95% of the CEF universe.

My long-running observation is that very few CEFs are proactive in addressing persistent discounts.  Yes, some funds have stronger governance than others.  Across the landscape, however, it is common to observe that the fiduciary duty to shareholders is, at best, a minor consideration.

The simplest manifestation of board proactivity in addressing discounts is the adoption of share repurchase plans.  Share repurchase at discounts generates gains that are accretive to NAV and benefit all shareholders.  Further, these repurchases should begin to remediate the supply-demand imbalance that gives rise to the discount (greater supply of shares than demand for them at prices at or near NAV).

While many funds have adopted share repurchase plans, few use them actively even when their discounts widen into the mid-teens and when share repurchase can generate riskless, instantaneous mid-to-upper teens gains on the amount repurchased – gains that far exceed the intermediate- and long-term total returns of nearly all CEFs.  To the extent share repurchase is executed, far more often than not, it is done only in token amounts.

Of course, there are additional, more authoritative measures fund boards can use to address discounts.  These include adopting formal discount-management programs, conducting tenders, merging multiple funds to create economies-of-scale, open-ending a fund so that it trades at full NAV or liquidating the fund, also for full NAV.  Whenever a fund board takes any of these more aggressive steps, it’s a reliable bet that the fund’s shareholder register has become populated with influential institutional investors who have pressed the fund’s board and managers to remediate the discount or, at minimum, take steps to monetize it for all shareholders’ benefit.

Are these institutional investors “activists”?  That’s a question for the beholder.  Whether they are or aren’t activists, they’re doing most of their work quietly and tactfully, improving fund governance and driving initiatives that benefit all shareholders, no matter how small.

It is rare, bordering on inconceivable, to see fund boards take steps to remediate discounts for the benefit of investors if the accompanying “cost” is a reduction of more than a trivial amount of AUM and, by extension, investment advisory fees …. in the absence of pressure from institutional investors, who, effectively, are “keeping them honest” and holding them to their fiduciary duty.

Instead of curtailing these investors’ voting influence by withdrawing the Boulder letter, the SEC’s Division of Investment Management should raise accountability for funds with persistent double-digit discounts.  SEC to Fund Board: “Why does your fund’s strategy justify a persistent discount?  How proactive and effective have you been remediating persistent discounts in the absence of pressure from institutional investors?  What is your plan for addressing persistent discounts within your current fund universe?  Or should investors simply be content to be ‘trapped’ in funds with deep discounts?  What tangible steps are you taking?  How much progress have your efforts borne?”

Historical shareholding records available via Bloomberg illustrate the large institutional owners who owned a given fund when it undertook overt action to combat a persistent discount.  These records can be used to assess cause-and-effect.

Notably, if fund boards were more proactive in policing discounts and preserving value for small investors, institutional investors and activists would be far less inclined to become investors in their funds.

My dialogue with closed-end fund managers and their investor relations representatives reveals that they are often dismissive of any obligation to address persistent double-digit discounts, proffering preposterous responses along the following lines:

1. “You shouldn’t buy our fund [with a persistent double-digit discount] with an expectation that we would take any steps to cause the discount to tighten”
2. “The virtue of the discount is that investors get to reinvest their distributions at a discount.”  Yes, that’s a virtue, but it pales versus the greater virtue of having the fund trade for the value of its assets;
3. “Yes, we spend a lot of time thinking about the discount and are frustrated by it.  But we trade at discounts similar to the other ’29 funds [funds created in 1929, more than 85 years earlier than the time of the discussion], so we take comfort from how our peer group trades”;
4. Specious assertions blaming low trading volumes for choosing not to repurchase more than trivial numbers of shares.

My observation is that the typical closed-end fund’s approach to governance is “We’ve raised permanent capital …. caveat emptor.”  Most CEFs which trade at persistent discounts have boards whose fidelity to the fee pool far exceeds the performance of its fiduciary duty to fund investors.  These fund boards effectively treat retail shareholders as “trapped.”

Candidly, I find it surprising that any serious investment manager would adopt provisions as anti-democratic as the so-called “Control Share Statutes” (CSS) that the Boulder Letter withdrawal facilitates.  Yet, several purportedly serious investment managers have already opted in (Duff & Phelps, Prudential, Legg Mason, perhaps others).

Presumably, serious investment managers would be absolutely livid if their voting rights in investees were curtailed.  Investment managers might reasonably feel an obligation to fight such a curtailment.  For any investment manager who expects full voting rights to be preserved at the companies in which it invests, opting into a CSS is sheer hypocrisy.

Contrary to the Investment Company Institute’s narrative, it’s not institutional investors, or the so-called activists, who imperil the closed-end fund industry.  Rather, it’s persistent discounts, fund boards’ indifference to these discounts and the consequent difficulty in raising new funds at net asset value when deep discounts so broadly populate the CEF universe.  Stated differently, the fund industry struggles to raise new closed-end funds at “full price” when the discount rack is bulging.  If fund boards were more proactive and impactful in addressing the discounts, the market would be far more reliably hospitable to the creation of new funds.
 
The so-called Boulder Letter is a thoughtful, rational guardian of democratic principles that play a key role in preserving value for small investors.  It should be restored.

At minimum, any effort to withdraw the Boulder Letter that is not fully transparent, allowing the full range of market participants to engage in the dialogue, defies the ’40 Act and is a shameful abdication of the SEC Division of Investment Management’s mission to protect small investors.

I am willing to discuss my experiences and observations in the closed-end fund space in greater detail.  Thank you for your consideration.

Sincerely,

Chris Whitman