Lazard Insights The World at a Discount Edward Keating, Senior Vice President, Client Portfolio Manager Summary In the investment world, analysts and market participants are constantly seeking discounts in asset classes or individual investments. The structural nature of closed-end funds causes these investments to be typically discounted. In many respects, closed-end funds are not different from their well-known open-end (mutual fund) counterparts. However, a key distinction is that closed-end funds price is independent of net asset value thus creating the opportunity of a discount. Value for closed-end fund shareholders is unlocked as discounts narrow. A well-considered corporate governance initiative is an effective way to decrease the discount. Lazard Insights is an ongoing series designed to share valueadded insights from Lazard s thought leaders around the world and is not specific to any Lazard product or service. This paper is published in conjunction with a presentation featuring the author on 24 June 214. The original recording can be accessed via www.lazardnet.com. Buying at a Discount, a Basic Concept In every market system, participants are constantly seeking assets or products selling at discounts. Whether in consumer goods or financial assets, the opportunity of obtaining a bargain drives the constant search for discounted prices. Investing in companies perceived to be attractively priced is not a new concept. If, for example, shares of IBM are viewed as attractive an investor can buy the shares. But if these mispriced shares are held in a closed-end fund that is also trading at a compelling discount the investment opportunity becomes more attractive. This simplified example delineates the basic concept in the typically inefficiently priced world of closed-end funds. While many investment vehicles and strategies are a byproduct of recent innovation, closed-end funds were first established more than 145 years ago. In 1868, the first traffic signals were installed in London, Thomas Edison filed his first patent, the city of Edo was renamed as Tokyo, and Foreign and Colonial Management launched the first closed-end fund the F&C Investment Trust, which is still being managed today. The F&C Investment Trust was set up to offer UK investors the opportunity to gain ready access to the most exciting emerging market at that time, a country known as the United States of America. In 1868 investors turned to closed-end funds, seeking exposure to global equity markets through professional management teams experienced at delivering consistent alpha. This continues to be true today.
2 As a basic definition, closed-end funds are professionally managed investment companies that commingle investors funds and invest according to a prospectus. In this respect they are not different from open-end funds (i.e., mutual funds). However, a central difference between the two is that closed-end funds come to existence through an IPO process and its shares trade like a company on a stock exchange with its price independent of net asset value (NAV). Exhibit 1 summarizes key features of closed- and open-end funds. Exhibit 1 Comparison of Closed- and Open-End Funds Closed-End Funds (CEFs) First Fund Launch 1868 1923 Open-End Funds (Mutual Funds) # of shares/aum Fixed Continuously offered Trades/Priced Throughout day Once daily Share Prices Independent from NAV Dependent on NAV Can Trade at Premium/Discount Key Decisions Made by Board Yield Enhanced by Discount This information is for illustrative purposes only. Source: Lazard No, in conjunction with manager No Importantly, given that the price trades independent of NAV, a closed-end fund s price can be at a premium or discount to NAV. The phenomenon of the discount is central to investing in these vehicles and can be interpreted at two levels: 1) the price of the closed-end fund itself can be at a discount; and 2) the underlying holdings in the fund can be priced at a discount. The combination of attractively priced holdings within a discounted fund can be an intriguing investment option, in our view. The Closed-End Fund Universe Many observers perception is that closed-end-funds compose a shallow investment universe; however, contrary to this view, the universe is large and globally diverse. There are approximately 1,5 closed-end funds globally with a total market capitalization of about US$5 billion. If one includes holding companies, which closely resemble closed-end funds as they also hold the majority of their capital in other listed companies the combined investable universe is about US$2 trillion, a large investable universe that generally remains inefficiently priced. 1 Capital raised in closed-end funds continues to grow. The two largest venues for these assets are the New York Stock Exchange and the London Stock Exchange, and in 213 nearly US$3 billion in assets were raised (Exhibit 2). We also are encouraged that new capital in closed-end funds has rebounded and risen steadily following the global financial crisis in 28 29. Exhibit 2 The Closed-End Fund Universe Continues to Grow Assets Raised ($M) 6, 4, 2, 1996 1997 1998 1999 2 21 22 23 24 25 26 27 28 29 21 211 212 213 Mar-14 United States 7 5 6,5 2,3 3 6, 16,4 3,1 23,7 21,3 1,622 27,61 262 2,596 7,671 5,888 11,82 14,99 695 Europe 9,382 1,871 United Kingdom 2,811 937 2,122 453 2,16 976 573 1,121 2,888 11,53 17,11 21,247 5,85 4,652 6,69 4,631 5,511 11,529 1,76 As of March 214
3 Performance and Diversification A key benefit of a closed-end fund is the opportunity to gain diversification with a single investment, which is not different than what is possible through a traditional mutual fund. However, there is an added operational advantage to closed-end funds, as an investor can simply trade funds shares on a stock exchange. In similar fashion to mutual funds, capital in a closed-end fund will be invested across a portfolio of companies selected by a professional investment team targeting specific investment objectives, which can be, for example, regions or sectors. However, the typically discounted nature of closed-end funds implies that a portfolio of carefully selected closed-end funds presents a unique way to access global markets with great diversification and potential for favorable results. Structural advantages can lead to persistence in outperformance over mutual funds. There are no cash in/out flows in closed-end funds, which in many instances can be disruptive to the investment strategy. This critical feature allows for a greater ability to focus on a longerterm horizon, take higher-conviction positions, and own smaller-cap investments. Inflows into mutual funds need to be allocated to new investments (or additions to existing positions), which may lead to less-than-optimal positions as, hypothetically, the best ideas may be already fully invested or may present capacity issues. Outflows via share redemptions in open-end funds mean that positions need to be sold to meet liquidity requirements, or a cash position causing a performance drag must be maintained. Evaluating the performance of closed- and open-end fund universes in key regions and through different time horizons, we observe that closed-end funds have consistently outperformed mutual funds (Exhibit 3). Clearly, outperformance will not occur during every time period and across all funds, but the analysis is compelling. As noted, the structure of the closed-end funds themselves can be part of the explanation for these results. Demystifying the Discount Why do closed-end funds trade at a discount? This question has puzzled academics and practitioners for a long time. In fact, this phenomenon caught the attention of famous investors and thought leaders such as Benjamin Graham and Burton Malkiel. 2 Contrary to a popular notion, Graham observed that the discount is not a function of poor investment management quality, which could lead to poor performance. We believe the results in Exhibit 3 support Graham s observation. Malkiel a proponent of the efficient market hypothesis stressed that the discounts are simply unexploited market inefficiencies, which is essentially what most investors seek. We analyzed closed-end fund discounts over time for those listed in the United States and the United Kingdom (the largest venues for these assets). Discounts can be volatile and typically widen during times of uncertainty and, not surprisingly, narrow during more positive economic times (Exhibit 4). On average, discounts fall in the 5% 1% range. Keep in mind this is a universe average, so our sample includes closed-end funds whose price trades either at a discount or a premium to NAV. Naturally, investors have the opportunity to select only those they deem attractive. Exhibit 5 shows a current distribution of the number of funds globally by the range of discount or premium. This sample illustrates that many closed-end funds trade at a discount (approximately 8% of funds). Importantly, a significant amount of assets under management are concentrated in discounted closed-end funds, as shown below the graph in Exhibit 5. As a result, investors have the opportunity to be highly selective drawing from a broad and deep universe to choose investments trading at a discount, while avoiding those at a premium. Exhibit 3 Persistent Outperformance over Open-End Funds Morningstar Fund Category 1 Year 3 Years 5 Years 1 Years China Region Diversified Emerging Markets Diversified Pacific/Asia Latin America Stock Pacific/Asia ex Japan Stock As of 14 June 213 This information is for illustrative purposes only. The performance quoted represents past performance. Past performance is not a reliable indicator of future results. The performance presented above does not represent the performance of any product managed by Lazard. Data are based on Morningstar s open- and closed-end fund universes for each category. Source: Aberdeen, Morningstar, Fund Consultants LLC Exhibit 4 The Historical Average Discount for US- and UK-Listed Closed-End Funds Ranges from 5% to 1% Average Discount to NAV (%) 5-5 -1-15 -2 2 22 24 26 28 21 212 214 United States United Kingdom As of 13 June 214 Value weighted average discount to NAV.
4 Exhibit 5 A Significant Amount of Funds (and Assets) Trade at a Discount Number of Funds 4 3 Premium Discount 2 1 3% and higher 15% 3% 5% 15% % 5% % % 5% 5% 1% 1% 15% 15% 2% 2% 25% 25% 3% 3% and lower AUM ($M) 14,542 21,598 34,76 51,6 1,3 12,752 22,142 17,882 22,53 3,479 3,825 31,747 As of 11 June 214 Based on Morningstar s closed-end fund universe. Identifying the reasons why closed-end funds trade at discounts and potential catalysts to close the discount gap is crucial because narrowing the discount is eventually what creates value for shareholders. Just like any other publicly traded company, closed-end funds are influenced by shareholders in order to unlock value. There are a multitude of reasons why closed-end funds may trade at a discount or premium to NAV, including market sentiment perhaps investors have negative views on certain asset classes or regions (e.g., recently, emerging markets or China). Conversely, some may have overly optimistic views (e.g., recently, some bond funds, or other yield-oriented investments). In other instances there may be poor communication from the board of directors, lack of transparency, high fees, low liquidity, or simply the manager may be of mediocre quality. Exhibit 6 Adding Value through Corporate Governance Initiatives Corporate Governance Approach Consult with the Management & Board Communicate our investment thesis with the Board Share peer analysis; knowledge of what peers are doing Analysis of corporate communications Review Board membership Potential Solutions Discount management plans Distribution policy (dividend, capital return, divestment) Simplifying corporate structure Manager reorganization Mergers & acquisitions Tender offers, share buy backs Open-ending, liquidations Recommend member candidates for the Board Directly addressing these issues with the manager or board in a cooperative fashion (i.e., improving the corporate governance of the investment company) is a sound approach that can potentially narrow the discount. Often times, corporate governance initiatives are associated with aggressive shareholder activism. However, our view is that a well-thought cooperative approach can be much more successful. Not surprisingly, those shareholders with substantial stakes (in the range of 1% 15%) stand to have greater bargaining power with the board and management. With that said, every shareholder will benefit from the unlocked latent value derived from corporate governance improvements. In a more cooperative corporate governance approach an investor acts as a consultant. A summary of some of the corporate governance initiatives and potential solutions that may narrow a closed-end fund s discount are displayed in Exhibit 6. Conclusion We believe closed-end funds have attractive benefits for investors today, as they did more than 145 years ago. The potential for diversification and favorable performance stemming from buying a discounted investment appear to be compelling motives for many investment decisions. In addition, a portfolio composed of closed-end funds presents a unique option to access global equities. Many observers view the discount of closed-end funds with negative connotations, for example, as a signal of poor investment management quality. However, we stress that the opportunity lies in the discount, which appears to be the symptom of market inefficiency. In our view, an optimal method to add or unlock value by moving the discount closer to NAV in a closed-end fund is through a sound cooperative and coordinated corporate governance approach. This information is for illustrative purposes only
5 Notes 1 Includes closed-end funds that can invest in areas including fixed income securities, real estate, private equity, closed-end funds; also includes closed-end funds that may invest across asset classes (equity and fixed income, for example). Source: Lazard. As of 19 April 213. 2 Graham, Benjamin. 1949 (Revised edition 23). The Intelligent Investor: The Definitive Book on Value Investing. New York: HarperCollins. Malkiel, Burton. 1973 (Revised edition 1999). A Random Walk Down Wall Street. New York: W.W. Norton & Company. Important Information Originally published on 1 July 214. Revised and republished on 11 July 214. Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. The securities and/or information referenced should not be considered a recommendation or solicitation to purchase or sell these securities. It should not be assumed that any of the referenced securities were or will prove to be profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile, and less subject to governmental supervision than in one s home market. The values of these securities may be affected by changes in currency rates, application of a country s specific tax laws, changes in government administration, and economic and monetary policy. Emerging-market securities carry special risks, such as less developed or less efficient trading markets, a lack of company information, and differing auditing and legal standards. The securities markets of emerging-market countries can be extremely volatile; performance can also be influenced by political, social, and economic factors affecting companies in emerging-market countries. The shares of closed-end funds and investment trusts may trade at prices at, below, or above their net asset value. There is no guarantee that a fund s discount will ever be narrowed or eliminated. An investment in either type of fund is indirectly subject to all the risks associated with the investments made by the funds themselves. 214 Morningstar, Inc. All rights reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar not its content providers are responsible for any damages or losses arising from any use of this information. This paper is for informational purposes only. It is not intended to, and does not constitute financial advice, fund management services, an offer of financial products or to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security, or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 64 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-6311 Frankfurt am Main. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 17-52. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 1F Seoul Finance Center, 136 Sejongdaero, Jung-gu, Seoul, 1-768. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset Management Ltd., 5 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place, #15-2 One Raffles Place Tower 1, Singapore 48616. Company Registration Number 211355W. This document is for institutional investors or accredited investors as defined under the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United States: Issued by Lazard Asset Management LLC, 3 Rockefeller Plaza, New York, NY 1112. RD199