ETF Liquidity Knocks Out Competition
June 16, 2003
The closed-end fund world has been under siege by a rash of exchange-traded funds in recent years, triggering a dramatic shift in the focus of equity-fund initial public offerings (IPOs).
The sea change first began back in 1997, as IPOs for country and region funds began to disappear, according to a research report from Denver-based fund tracking firm Lipper. The emergence of single-country ETFs has had a tremendous impact on both the creation and dissolution of comparable closed-end funds, said Don Cassidy, senior research analyst at Lipper.
He noted that they have also been the likely cause for the considerable widening of discounts among world-equity closed-end funds, making it the only fund product to suffer that fate. As a result, the road ahead for pure equity closed-end funds looks particularly bumpy as they face a battle for market share while prospects for IPO opportunities have been "severely constrained."
In terms of the numbers, between 1986 and 1995, there were 108 equity closed-end fund IPOs unveiled to the marketplace, the report revealed. Within that universe, 71 of them were world-equity funds. The period ranging from 1996 to 2002 reveals a striking difference, however, producing only 28 IPOs of equity closed-end funds, only one of which was a world equity fund. The IPO shift is the result of a combination of long-term forces and cyclical trends, Cassidy said. The large number of offerings during the 1986 to 1995 period addressed a need for such vehicles to a certain extent, and only a handful of countries with developed markets failed to see U.S.-listed closed-end funds come to market.
iShares, Country Baskets
Still, the multiplicity of funds was clear, which suggests that more IPOs might have been possible if not for a major turning point in the industry. "That watershed, we believe, was the emergence of country-index funds beginning in March 1996," Cassidy said. The inception of iShares, formerly known as WEBS, and country baskets put the kibosh on the issuance of new single-country closed-end funds. What was even more dramatic, he said, is that the growing popularity of iShares and country baskets ultimately led to the en masse liquidation and open-ending of previously existing country equity closed-end funds.
The competitive advantage of utilizing ETFs lies in their innovative structure. Essentially, ETF shares can be created or destroyed in institutional-sized blocks through in-kind exchanges of securities. According to Cassidy, that would imply that if there were significant demand for the product, the market would be kept efficient by arbitrageurs, to the extent that only small discounts of 0.5% or less will arise. Given that investors are inherently more risk-averse than risk-seeking, premiums and discounts offered by closed-end funds are more of a problem than an opportunity, he said.
Closed-end funds, which also trade on exchanges, are different from ETFs in that they have a static amount of shares outstanding. For that reason, a close-ended fund typically trades at a premium or a discount to its net asset value for a protracted period of time. Exchange-traded funds, on the other hand, trade close to the net asset value of the underlying portfolio since new ETF shares can be created and redeemed.
While there is no hard evidence to support the fact that a shrinking number of closed-end funds can be directly attributed to the rise of ETFs, it can hardly be dismissed as a coincidence.
Barclay's Global Investors of San Francisco has created 16 country and one regional iShares, which have competed against pre-existing closed-end funds. Thirteen of those closed-end funds have been dissolved or are at least in the process of shutting down.
The list includes Austria, Emerging Germany, Fidelity Advisor Korea, Korean Investment Fund, Emerging Mexico, Scudder Spain & Portugal, Growth Fund of Spain, The United Kingdom Fund, Taiwan Equity Fund, Morgan Stanley Emerging Markets and Templeton Emerging Markets Appreciation. The Italy Fund will close its doors in February, and the France Growth Fund is currently in jeopardy as well.
Among the 21 countries that are not matched with ETFs, Lipper revealed, there have been only three departures. One of these was Argentina, which fell victim to the Securities & Exchange Commission's new rules requiring that the assets in a mutual fund and the investment style suggested by the fund's name more closely match each other. The SEC now requires that at least 80% of a mutual fund's assets be invested in those securities implied in a fund's name, compared to the previous 65% minimum requirement.
Recent reports have indicated that the next ETF to be introduced will be for China, a nation where several closed-end counterparts already exist. Given the tremendous success ETFs have enjoyed since their inception, Cassidy believes it will be difficult to encourage individual brokers to sell a pure-equity closed-end fund on the IPO market.
"Clearly, thus far, the battle has gone to the ETFs," Cassidy said. "Given their extensive and concentrated marketing muscle and the public's aversion to risk, it seems that being optimistic about equity closed-end funds regaining relative position requires rose-tinted glasses."
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