Unlocking Value In Closed-ended Funds

By Justin Kuepper | April 18, 2007 AAA

Many investors think of mutual funds as groups of stocks that trade at a price equal to the total value of those stocks divided by the number of mutual fund shares outstanding. These mutual funds are called open-ended mutual funds, and they are by far the most common type of mutual fund available.

However, there is another type of mutual fund that trades at a price based upon supply and demand of its own stock, rather than the value of its holdings. These mutual funds are called closed-ended mutual funds, and they can present great profit opportunities for investors!

These opportunities arise when the mutual fund trades below its net asset value (NAV)-- that is, when the total value of the fund's holdings exceeds its stock price. Why does something like this happen? Well, it happens for variety of reasons including a negative future outlook, simple lack of liquidity or even ignorance.

So, the question then becomes: How do we know if this discount to NAV is legitimate? Well, we could dig in and do a lot of research into the industry prospects and individual portfolio holdings. Alternatively, we could simply piggyback on successful Wall Street hedge funds that are already taking measures to close the gap between the NAV and stock price!

Here are some current opportunities in the sector:

MFS Government Markets Income Trust (NYSE:MGF)
Karpus Management Inc., an 8.36% holder of the company, officially proposed in a letter dated March 27 that shareholders vote at the next shareholders meeting to have the fund conduct a tender offer for up to 25% of its outstanding shares at NAV.

Furthermore, Karpus proposed that the fund establish a policy whereby, if the fund trades at an average discount of over 10% for the 10 calendar weeks prior to the end of June 30 or December 31, then the fund conduct semi-annual tender offers of 5% of the fund's outstanding shares at NAV.

Obviously, these proposals would let shareholders redeem their shares at NAV and help close the gap between the NAV and current market price of MGF. While this is no guarantee, it is certainly a situation worth following as the annual meeting approaches.

American Strategic Income Portfolio Inc. (NYSE:BSP)
Sit Investment Associates, a 33.28% holder of the company, noted on April 16 that the shares of the issuer had been trading at a significant discount to NAV during the past several years. As a result, the hedge fund has recommended that BSP provide a limited opportunity for shareholders to redeem their shares at NAV or pursue other means that would enable shareholders to realize the NAV of their shares.

Another proposal was to convert the company into an REIT since the majority of its holdings were real estate holdings. The move would enable it to benefit significantly from tax savings associated with being organized as an REIT, and it would also require the company to return a higher percentage of its earnings back to shareholders in the form of a dividend.

Notably, BSP did agree to repurchase 10% of its shares back in December of 1999 when the hedge fund made a similar proposal. While it may take time before a proposal like this is adopted, BSP is definitely a stock to keep on the radar.

AEW Real Estate Income Fund
Stevenson Capital Management, a 9.9% holder of the company, demanded that AEW take whatever steps are necessary to reduce or eliminate the discount to NAV. The proposed solutions included liquidating, open-ending the fund, launching a tender offer, or taking other steps to unlock value. SCM took things a step further by threatening to replace the fund's board of directors with its own candidates that would institute change if necessary. According to SCM, such actions could result in a $5 per share capital gain on a stock that had a share price of only $22 in January of this year!

Other Opportunities
There are a number of closed-ended funds that trade well below NAV and many of them do not deserve their valuation. While one strategy is to watch hedge funds through their Schedule 13D filings and piggyback on their trades, another strategy is to do a pairs trade between an undervalued and overvalued fund in the same category. Either way, these situations represent great opportunities for investors!

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