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BLOG: The red flags investors should watch out for in closed-end funds

Paloma Kubiak
Written By:
Paloma Kubiak

One of the most important starting points in investing is knowing where to look for opportunities, yet what is perhaps more difficult is knowing exactly what characteristics to look out for.

Closed-end investment funds – some of which are also known as investment trusts – are a popular option for investors and the sector has expanded rapidly in recent years.

This widening of the opportunity is surely good news for investors; however, with more choice comes greater difficulty in trying to sift the good from the bad.

It’s crucial to be aware of the positive signs that suggest a strong investment opportunity. In the closed-end space this might involve judging the robustness of the investment manager’s philosophy, the strength and independence of the board which provides oversight for the fund, or perhaps the long-term performance.

Equally, if not perhaps more important, is to be aware of the factors that should raise a red flag before you hand over your savings.

Looking past the marketing spiel and examining the detail of a closed-end fund is a vital habit to adopt. Checking a closed-end fund’s factsheet to find out if it is trading at a premium or discount to its net asset value is a good starting point. If it is trading at a discount – where the closed-end fund’s net asset value is higher than the value of its shares – an investor should question what is driving it.

A closed-end fund can trade on a discount for a multitude of reasons. Wide discounts often occur if there is question over the validity of the asset value, poor corporate governance, or where the assets are distressed. Closed-end funds exhibiting these characteristics should be treated with caution.

This is not to say that a wide discount is always a warning sign. Sometimes, the market’s perception of the fund fails to keep pace with changes and improvements that have been made, resulting in an anomalous discount and, potentially, a ‘bargain’ price.

This situation can occur even for high-quality closed-end funds. Times change, and a discount can be a good entry point to a fund that has made improvements that aren’t yet recognised in its share price. Nonetheless, do your research to make sure the discount isn’t there for good reason.

Focus on research

When looking for other red flags, the key to uncovering warning signs involves digging into the detail. Are there any signs of trouble being stored up for the future?

Examining what we call ‘qualitative’ factors, such as the effectiveness and performance of the board, forms part of this process. Ask yourself, does it have a history of standing up for the fund’s shareholders? Or has it perhaps shown an inclination to act in the manager’s best interests rather than those of shareholders?

A strong board should be fully independent from the investment manager, enabling it to question decision-making and ensure it always works in the best interests of its shareholders (i.e., you, the investor).

The voting structure is another important area. Do all shareholders have full voting rights? If not, it could make it more difficult to enact change, and can be a sign that the fund is not open to development. Examining the shareholder base is also crucial – are there large shareholders resistant to change?

A further area of concern is management contracts. Terms which include a punitive termination clause can prove restrictive – there are examples of funds where the termination of the management contract triggers a payment of multiple years of management fees. Clauses such as these can often prove a barrier to a restructuring that may be in the best interests of shareholders.

When it comes to the underlying investments, again looking into the detail is important. You could find the fund does not directly own the assets in which it invests, instead acting  as a feeder fund into a master fund run by the investment manager, and that master fund will in turn own the underlying assets. This kind of relationship can sometimes mean the board does not have full control over the underlying assets, in which case the fund’s directors may be powerless to intervene or order a sale of assets – something to be concerned about if performance faltered.

Ultimately, you must make an investment based on your own judgement and personal circumstances. Selecting where and with whom to trust your savings can be a difficult one to make, but with the right knowledge and understanding of the warning signs, an investor can improve their understanding of the risks involved, with hopefully superior long-term results.

Tom Treanor is head of research at AVI Global