Closed-End-Around

August 20, 2006

First Trust Advisors moves to convert two closed-end funds to exchange-traded status.

In a move that could shake the closed-end fund industry to its core (and create significant investment opportunities for savvy investors), First Trust Advisors is moving to convert two deeply discounted closed-end funds to exchange-traded status. 

According to the Wall Street Journal, the board of two First Trust closed-end funds - the First Trust Value Line Dividend Fund and First Trust Value Line & Ibbotson Equity Allocation Fund - have approved a reorganization of the funds into exchange-traded funds (ETFs). Shareholders are expected to vote on the deal before December 15, and if they approve of the move, the funds will convert no later than January 31.

The move could prompt a significant re-valuation of the two funds, and, indeed, of all passively managed closed-end funds. Closed-end funds often trade at steep discounts to their net asset values - the Journal says that the two funds traded at discounts of 12-13 percent most of last year. That discount has narrowed substantial since rumors of the ETF conversion began to leak onto the market at the start of this year.

The key difference between closed-end funds and ETFs is that ETFs have a creation/redemption mechanism, whereby shares can be exchanged for the underlying assets at any time. In other words, if you have enough shares of the Nasdaq-100 ETF (NDAQ: QQQQ), you can trade it in for the underlying shares of all 100 companies in the index; conversely, you can deliver shares of the underlying company and receive shares of QQQQ in exchange.

This ongoing creation/redemption mechanism gives institutional investors an incentive to arbitrage any discrepancy between the value of the ETF and the value of the underlying assets.

Closed-end funds do not have this creation/redemption mechanism, so the arbitrage market does not exist, and discounted funds can and do exist for long stretches of time. Assuming shareholders of the First Trust funds approve the conversion to ETF status, one would expect the discount to disappear altogether.

Closed-end funds have converted into traditional mutual funds in the past, as a way of eliminating persistent discounts.  But in most cases, management recommends against conversion, and most conversion votes fail. Management is incentivized to vote against conversion, as assets often fall if investors are given the opportunity to cash out at the NAV.

 

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