September 21, 1998…Rockville, MD…Over the past two years, the closed-end fund industry has seen an increase in shareholder activism, most notably an effort on the part of shareholders to convert closed-end companies to open-end status. The increasing activism, often triggered by the desire for short-term gains, can mask the benefits of the closed-end structure and blemish a misunderstood investment class.

This research study shows that converting to the open-end fund structure damages long-term investors who continue to hold the converted fund. This study discusses the conversion issues faced by existing shareholders. It also explains the benefits of the closed-end fund structure and compares closed-end to open-end funds. This analysis uses data from the past two years provided by Wiesenberger. The funds included in the different sections of this report are based upon the availability of that data.

What happens to a fund which open-ends?

Just as certain investors are attracted to open-end funds, others choose closed-end funds based on their specific characteristics. Recent conversions from closed-end to the open-end structure may have an adverse impact on long-term shareholders. Generally, the goal of an open-end conversion is to eradicate the discount, not necessarily to address a deficiency in returns (see table 1).

Table 1: 12 month market returns of selected CE funds prior to open-ending. 12 month return is as of conversion date

Those shareholders who desire conversion perceive their shares as undervalued when compared to the value of the fund’s portfolio.

Usually, a fund’s discount will narrow considerably within a few days after an open-ending announcement. This is seen most dramatically when the board of directors announces approval of a fund's conversion (see table 2).

Table 2: When the Board of Directors announces endorsement of a conversion proposal, an increase in market price usually follows - resulting in a sharp decrease in the fund’s discount to net assets.

* The board of TCW/DW Emerging Mkts Oppt Tr announced that an open-ending proposal would be on the shareholder’s ballot, but did not endorse the proposal.

When shareholders vote on an open-ending proposal, those who vote in favor of fund conversion fall into two groups: one which wants their shares to be valued at NAV and wants to remain invested in the fund (Group 1), and one which wants to capture the short-term gain in market price after an open-ending announcement by selling (Group 2). The rapid selling pressure caused by Group 2 following completion of open-ending has a detrimental impact over the long term on both the newly converted fund and Group 1 investors because of the following:

• Net assets plunge due to large redemptions
• Portfolio holdings are liquidated to meet redemptions
• Fund realizes significant capital gains
• Capital gains are distributed to shareholders, resulting in related tax liability
• Expense ratio increases due to reduction in total assets
• Investment style of fund may be altered

The Nasty Three: Net asset drop, capital gains, and taxes

The fund must distribute net assets to meet the redemptions caused by Group 2 shareholders. More often than not, there is not enough cash to meet those redemptions so the fund must sell-off portfolio holdings. This is because closed-end funds do not have to hold cash to cover redemptions. This helps the fund meet redemptions, but the portfolio sales result in capital gain and related distributions and related tax headaches to those shareholders who are members of Group 1 (see table 3).

Table 3: Capital gain distributions after conversion

Net assets from the converted funds were measured before and after conversion. Within six months after the conversion, the weighted average change in net assets was a decrease of 28.18%. Eight out of the nine funds decreased in net asset size due to shareholder redemptions - with the exception of Pilgrim America Bank & Thrift which grew in size due to the popularity of the banking sector towards the later part of 1997 (see chart 1).

Chart 1

*Data not available for Convertible Holdings

Less means more

As mentioned above, Group 2 shareholders head for the exits to cash in on the short-term market price gain. This leaves the newly converted open-end fund with a smaller asset base. Many expenses are fairly fixed and must be spread over a smaller asset base, resulting in an increased expense ratio (see chart 2). Based on data shown in the last financial report as a closed-end fund and the first financial report as an open-end fund, the average expense ratio increased from 1.33% to 1.89% after conversion to an open-end fund.

Chart 2

*Data not available for TCW/DW Emerging Mkts Opportunity Trust

Changes in Investment Styles

As mentioned in the benefits section of this study, closed-end funds operate with a stable asset base. Having fewer constraints allows closed-end funds to carry minimal cash amounts and enables them to invest in other securities that have greater total return potential. However, after a closed-end converts to an open-end, the portfolio manager must monitor shareholder redemption risk as a component to his/her investment strategy. This causes the manager to keep an adequate supply of cash on hand (see chart 3) in order to meet unplanned redemptions. The open-end portfolio manager can also have more cash than he/she would prefer. Because of the change in capital structure, the investment style of the fund may need to be altered to reflect a more risk averse investment style compared with a fund with a closed-end structure.

Chart 3 — Based on the last available survey data as a closed-end fund and the first available survey data as an open-end fund, converted funds tend to increase their cash position. Here, the amount of cash equivalent investments rises from an average of 2.43% as a closed-end fund to 7.75% as an open-end fund.

*Data not available for Convertible Holdings and TCW/DW Emerging Mkts Opportunity Trust

Conversions can eliminate the benefits of closed-end funds

The benefits of closed-end funds are many, including professional management, no-worry currency translation for international funds, discounted purchase prices, and, unlike their open-end counterparts, a stable asset base.

One of the primary benefits of closed-end funds is their stable asset base, which is a result of their legal structure. This allows the closed-end fund portfolio manager to be impervious to purchase and sales activity by fund shareholders. He or she can make longer-term investment decisions based on the fund’s investment strategy and outlook and not have to worry about potential redemption considerations.

Because open-end funds must continually react to purchase and redemption requests by shareholders, open-end funds tend to have a fluctuating asset base. This can cause an open-end portfolio manager to restructure the portfolio based on investor sentiment and not on investment philosophy. In addition, the open-end fund must keep an adequate supply of cash on hand to meet unexpected redemptions, making the open-end fund potentially less of a pure investment within its stated investment strategy.

On the other hand, if the asset base of an open-end fund increases, it allows the fund to spread fixed expenses over more assets, resulting in a lower expense ratio. However, if the net assets increase too rapidly, the open-end fund portfolio manager may have trouble investing the incremental assets in securities that fit the fund’s investment strategy.

A related feature of closed-end funds is that they are able to direct more investments into illiquid securities. Unlike closed-end funds, a Securities and Exchange Commission rule limits open-end funds to investing no more than 15% of their total net assets in illiquid securities. This rule was established in order to satisfy potential redemption requests of open-end funds. This allows closed-end funds to allocate more of their portfolio into non-publicly traded securities or into securities listed on less developed international financial markets, which may offer the potential for greater returns over a longer time frame.

Another basic difference is that closed-end funds can add leverage to their portfolio, whereas open-end funds are not allowed this opportunity. Leverage is the concept of investing borrowed funds or proceeds from a preferred stock offering with the expectation of producing a return exceeds the cost of obtaining these additional funds. This magnified returns, both positively and negatively, and the income generation potential for common shareholders.

One of the most commonly recognized benefits is the discount to net asset value (NAV) at which a particular fund’s shares trade in the marketplace. This exists when the market price paid for fund shares is less than the underlying value of the fund’s portfolio, or NAV. For example, if a fund trades at a 10% discount, a dollar’s worth of stock can be purchased for only ninety cents. In addition, the investor would enjoy the yield benefits of that full dollar’s worth in the form of income and capital gains. Basically, the discount is a form of free leverage for the investor in that he or she is buying more for less without the worry of margin interest payments. With the market price moving freely around a fund’s NAV, a changing discount can either enhance or diminish the return on a shareholder’s investment.

Conclusion

The closed-end fund structure has distinct characteristics. Investors may make an investment choice based on those characteristics. When closed-end funds convert to open-end funds, long-term investors lose the benefits they sought and may incur significant expenses. Based on the data examined in this study, conversion from closed-end to open-end structure is generally not in the best long-term interest of shareholders in the fund.

Wiesenberger, the country’s first mutual fund tracking service, has provided mutual fund data to financial professionals for more than 55 years. It is the leading provider of customized software to both distributors and sponsors, including financial planning companies, wirehouses, broker/dealer firms, banks, mutual funds and insurance companies. Wiesenberger is a division of Thomson Financial Services (TFS), a leading provider of information services and work solutions to the worldwide financial community. TFS employs more than 6,000 people in more than 40 locations dedicated to the success of our clients and is part of The Thomson Corporation. The principal activity of The Thomson Corporation (TTC) is information and publishing, where in 1997 the Group had some 40,000 staff members and a revenue base approaching US$6 billion.. TTC's common shares are quoted on the Toronto, Montreal and London stock exchanges. For more information, visit the TFS Web site at www.tfn.com.

###

The following Wiesenberger staff significantly contributed to this study:

Jack Brown

Dan Navarro

Maria Ketchledge