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Closed-end funds with a twist

Some funds now promise to convert to open-ended mutual funds or ETFs

FUNDS REPORTER

The arcane world of closed-end funds is trying to open up.

Harvest Banks & Buildings Income Fund, Canadian Shield Fund and O'Leary Founder's Series Income & Growth Fund are all poised to trade on the Toronto Stock Exchange.

They are part of a new breed of closed-end funds with a twist: They can or will convert to an open-ended mutual fund or exchange-traded fund (ETF) within two years.

It's a way to woo investors who are wary about buying closed-enders in case they can't sell their units at the fund's portfolio value. If there is little demand, the units can often trade below net asset value (NAV). Mutual funds and many ETFs trade at the value of the portfolio.

"Now, you have this ability to take advantage of a particular opportunity, and not worry about trading at a discount forever," says Michael Kovacs, chief executive officer of Harvest Portfolios Group Inc.

"The market debacle over the last 14 to 15 months has hurt [closed-end funds] severely," he said. "People rushing for liquidity ... sold their closed-end funds at even bigger discounts."

His firm's Harvest Banks & Buildings Income Fund begins trading tomorrow, and will become a mutual fund in October, 2011. This fund, which is permitted to use some leverage and targets a monthly 7-cent distribution per unit, is unique in that it will invest only in the banking and real estate sectors, Mr. Kovacs said.

About 150 closed-end funds now trade in Canada - down from some 180 a year and a half ago, according to data supplied by CIBC Wood Gundy. Some funds merged, while others wound up if they had termination dates.

For startup firms such as Harvest Portfolios, closed-end funds are a faster way to raise a lot of assets than starting a mutual fund from scratch. Closed-enders are typically marketed over six weeks by a syndicate of brokers.

Sentry Select Capital Corp. was among the pioneers in 2007 offering funds with a conversion feature in its prospectus in early 2007. Three have already converted to mutual funds, while Sentry Select Global Real Estate Fund will do so by next February.

Even mutual fund giant Mackenzie Financial Corp., a unit of IGM Financial Inc., is getting into the act. Mackenzie is trying to raise $250-million for the Canadian Shield Fund to be run by veteran money manager Roger Mortimer; it is slated to become a mutual fund in July, 2011.

O'Leary Funds Management LP expects to raise more than $120-million for its O'Leary Founder's Series Income & Growth Fund. It starts trading tomorrow and turns into a mutual fund in November, 2010.

The firm has also started the wheels in motion to get unitholder approval to turn two of its existing four closed-end funds - including O'Leary Global Equity and O'Leary Global Infrastructure - into mutual funds, too.

Unitholders of Front Street Resource Performance Fund have approved its conversion to a mutual fund in November. "The fund, at certain points of the liquidity crisis over the last 12 months, had traded upwards of a 50-per-cent discount to NAV," said Chris Fontana, director of sales at Front Street Capital Corp. "The market is dead for the closed-end funds of yesteryear."

Some closed-enders will convert to ETFs under certain conditions. Claymore Gold Bullion Trust, which raised $433-million this year, was "hugely successful" because of its conversion feature, he said.

The gold fund will change into an ETF if it trades at more than a 2-per-cent discount to NAV for 10 consecutive days after Nov. 28. Claymore Silver Bullion Trust is similar.

AlphaPro Management Inc., which is building a business of actively managed ETFs, also has a conversion feature in its AlphaPro Gartman and Horizons AlphaPro Tactical Bond closed-end funds. And it has filed a prospectus for its Horizons AlphaPro Inflation/DeflationProtection Fund that will go the same route.

The three convert to an ETF if they trade above the issue price, or at more than a 2-per-cent discount to NAV within certain time frames. Not surprisingly, AlphaPro's CEO Howard Atkinson argues that converting to an ETF is superior to switching to a mutual fund.

"What an ETF has in common with a closed-end fund of course is the intraday liquidity, and the listing on an exchange," Mr. Atkinson said. "Why wait until the end of the day [to sell]?"

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Discount disadvantage

Fund NameTickerNAVPricePremium/discount
Claymore Silver Bullion TrustSVR.UN-T12.1310.71-11.72%
Front Street Res. Performance*FRE-T8.617.80-9.42%
O'Leary Global Equity IncomeOGE.UN-T9.639.05-6.02%
Sentry Select Global Real Estate*GRE.UN-T6.916.61-4.34%
Claymore Gold Bullion TrustCGL.UN-T10.239.83-3.86%
Horizons AlphaPro GartmanHAG.UN-T9.599.38-2.19%
Canadian Convertible Deb.CDF.UN-T10.1110.10-0.10%
HAP Fiera Tactical BondHAF.UN-T9.1810.089.86%
As of Oct 20, 2009

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CLOSED-END FUNDS 'NOT FOR EVERYONE'

Closed-end funds may being appealing if they offer a unique investment opportunity. And units of newer issues may even come with a sweetener - a warrant to buy an additional one at a certain price.

But these exchange-listed funds "are not for everyone," and require heightened diligence compared with mutual funds because of the fees involved, independent fund analyst Peter Loach cautions.

A closed-end fund usually starts trading below the initial public offering (IPO) price because brokerage, legal and marketing fees are deducted. A $10-unit could drop to about $9.50 on the first trading day.

"Commissions on new issues are not necessarily printed on statements," Mr. Loach said. "First-year fees [including management expense ratio and trailer fees] can be excessively high - between 7.5 and 8.5 per cent in many cases."

Investors are also charged a fee of 3 to 4 per cent on the issue price to exercise a warrant, he added. "Long-term unitholders should ensure they hang onto the warrants and exercise them to avoid the possibility of being dramatically diluted. If investors forget to notify their financial institution [on a set day] that they wish to exercise their warrants, they also lose them."

Unless a closed-end fund offers access to a hard-to-reach sector, investors are often better off with a comparable investment like a front-end load or low-fee mutual fund or ETF, he added. "Some closed-end funds may charge a performance fee or use leverage that can add to the risk."

Fund analyst Dan Hallett has no qualms about buying closed-end funds, but not at the IPO. "You start a bit behind by the time the agent's underwriting fees are taken. ...

"The only reason you would buy at issue price is if you think it's a type of fund that might trade at a premium," he said. "Some gold closed-end funds trade at a premium, whereas for years they traded at a discount because they weren't very much in favour."

© 2007 The Globe and Mail. All rights reserved.

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