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Managing a Closed End Investment Fund Bierman and Swaminathan

Measures of success of a closed end fund are: Before and after tax return earned by investors Size of the discount (i.e., fund’s market value

minus market value of its investment assets)

Smaller discount is assumed to indicate market approval of management’s performance.

This study examines the issue whether or not market price discount reflects good or bad management.

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Managing a Closed End Investment Fund Bierman and Swaminathan

Malkiel (1995) - factors responsible for discount - premium: Unrealized capital appreciation Restricted Stocks Turnover Distribution (payout) policy Insider Ownership Expense ratios

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Managing a Closed End Investment Fund Bierman and Swaminathan

Past record of fund performance Proportion of foreign stock ownership Price level of shares Size of funds Investor sentiment about the stock market and the fund.

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Managing a Closed End Investment Fund Bierman and Swaminathan

In the absence of taxes and transaction costs, a well managed fund to have small discount and a badly managed fund to have large discount. Question to explore: Do taxes cause closed end fund to sell at discounts? If the fund has unrealized capital gains, this reduces the after tax value of the assets compared to the market value of the underlying assets.

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Managing a Closed End Investment Fund Bierman and Swaminathan

Example of unrealized capital gains tax effect:

1. Assume the market value = $150; tax basis = $50; capital gains tax rate = 20%; Capital gain = $100. If realized immediately; pay tax ($100x.20) = $20; Value to investor ($150-20) =$130; Size of the discount ($20/150) = 13.3%

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Managing a Closed End Investment Fund Bierman and Swaminathan

2. If market value is = $60; tax basis = $50; capital gains tax rate = 20%; Capital gain = $10. If realized immediately; pay tax ($10x.20) = $2; Value to investor ($60-2) =$58; Size of the discount ($2/60) = 3.33%

A seasoned fund with a relatively low investment turnover to have a higher tax discount than a relatively new fund that realizes capital gains rapidly.

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Managing a Closed End Investment Fund Bierman and Swaminathan

The discount also depends on whether the investors expect the fund to sell the appreciated asset.

3. What if the fund does not sell the stock? The fund is worth $150. If the stock is not to be sold, there is no discount for taxes.

Therefore, the value of the fund ranges from $130 to $150.

The high tax investor may prefer to defer the realization of gains and resulting taxation.

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Managing a Closed End Investment Fund Bierman and Swaminathan

Cost of realized gains: Does the opportunity to buy at a discount outweigh the impact of the capital gains realization and the resulting taxes? Assume that investors have two options: i) Buy a stock worth $150, or ii) consider the following closed end fund - a share of closed end fund=$130; net asset value = $150; tax basis = $50; tax = $20. In addition, fund will realize $17 capital gains every year to perpetuity. At 20% tax rate, the annual capital gains tax = $3.40.

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Managing a Closed End Investment Fund Bierman and Swaminathan

Time Cash Flow

0 +$20 Discount

1 - 3.40 Incremental capital gains tax

2 - 3.40 Consider the cost of borrowing ($20) is 17%

Decision to invest in the fund or the underlying stock: If cost of borrowing < 17% : buy stock If cost of borrowing > 17% : buy fund

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Managing a Closed End Investment Fund Bierman and Swaminathan

The amount of discount, considering the tax effects, depends on: The tax basis The tax rate Expected growth rate in stock price Time horizon Relative importance of dividends and capital gains The discount rate

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Managing a Closed End Investment Fund Bierman and Swaminathan

In summary, management of a closed end fund wants to maximize the after tax return to its investors. A tax sensitive fund management will face an increasing discount as the fund ages and capital gains accumulate. The value of the fund with unrealized capital gains will be less than the market value of the fund’s investments.

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Managing a Closed End Investment Fund Bierman and Swaminathan

From the tax perspective of the current investors, the fund should not realize capital gains; prospective investors, due to unrealized capital gains, will reduce the fund’s market value to below NAV. How to reconcile this difference - Establish a policy of not realizing capital gains for ‘n’ (defined) period and attract investors with n period planning horizon. Discount does not imply that management has failed to manage a closed end fund properly.