World equity Funds

Nearly 70 country, region, and world-equity closed-end funds are available, almost all actively traded on the New York Stock Exchange. As this article was written, they stood at a median discount of 24%, within 2% of their all-time deepest markdowns relative to net asset value. Many academic studies have indicated that discounts and premiums tend to eventually revert to their long-term averages. Even if only some of the discount is erased over time, funds representing underpriced assets (emerging markets, Asia, Japan, and Latin America) can provide meaningful profits for the patient investor as both the net asset value and discount improve.

In addition, it is well-documented that the open-ending/liquidating pressure brought on closed-end funds by insurgent investors focuses nearly entirely on deeply discounted funds and especially on foreign-investing funds (where institutional-holder allies can most readily be found).

In the 1990s, about 2% to 3% of all closed-end funds liquidated or open-ended annually on average, but the percentages were much higher in country funds. And the profits are more attractive than at first glance: A fund that is at a 25% discount gains 33% (for instance, from $75 to $100 net asset value) when these events occur, holding aside the trend of underlying net asset value, of course.

That trend may be even further magnified by the emergence of a new fund competitor—the exchange-traded fund. Dozens of exchange-traded funds have sprung into being in recent months, with assets now over $50 billion and surging. The oldest, called World Equity Benchmark Shares (WEBS) at their March 1996 debut, but now renamed “iShares MSCI,” focuses on individual countries’ markets, offering nearly complete index-fund qualities but adding the choices that intraday trading on an exchange (American Stock Exchange) bring. [For more on exchange-traded funds, see “Exchange-Traded Funds: A New Twist on Index Investing” by Albert Fredman, in the July 2000 AAII Journal.] Originally, many analysts thought exchange-traded funds might help close discounts on closed-end funds, since some investors would seek arbitrage plays when the latter traded widely below net asset value. Instead, it appears exchange-traded fund have become substitutes: Their relative volumes have risen, and in most cases trading in an exchange-traded fund now exceeds that for the same country’s closed-end fund. Since investors and traders prefer liquid markets, such advantages tend toward self-perpetuation. No one can prove any single cause, but a suspiciously above-average percentage of closed-end funds that have matching iShares have dissolved or open-ended since 1996, eliminating discounts in the process. Among the examples are closed-end funds that invested in the UK, Germany, Spain, and Mexico. And since 1996, when WEBS first appeared, the number of new closed-end funds investing in countries for which exchange-traded funds exist is exactly zero. More countries were added to iShares’ coverage last summer, and some regional and industry exchange-traded funds are now available, with even more coming. These have significant advertising support and proactive public relations campaigns by the Amex, Barclays Global, Merrill Lynch, and Morgan Stanley; Vanguard as well as Nuveen are expected to enter the arena in the near future.

Institutional and individual investors alike prefer the way exchange-traded funds trade, without risk of wide discounts developing. By contrast, closed-end funds almost totally lack aftermarket support. One could make a reasonable case that exchange-traded funds might crowd out closed-end funds where investors have alternate means of investing in the same securities. Nearly 20 country funds, a dozen or more regionals, and worldwide emerging-market closed-end funds, plus over a dozen that focus on industries and sectors (e.g., real estate, health/biotech, technology, energy, utilities, and small caps) could become open-end or liquidation candidates if they trade at persistently uncomfortable discounts.

Discounts that holders regret and resent are discounts that potential raiders love. Herein lies a chance for astute investors, who are patient and willing to buy what is out-of-favor at considerable discounts, to perhaps reap considerable profit in a neglected corner of the market.

Preferred Stocks

Generally, it is difficult to justify long-term ownership of non-convertible preferred stocks for individual investors. Here, the safety of the fixed payment is obviously subordinate to that of the corporate bonds, yet the cash yields offered by preferred shares tend to be lower because of tax benefits that only corporate investors can use. Thus, preferred stocks are priced to reflect corporate buyers’ desired returns.

Occasionally, however, interesting opportunities arise in preferred stocks. December 1999 was one such time, and a smaller echo may occur this winter. Many companies—including real estate investment trusts (REITs) utilities, and a few closed-end funds, among others—issued $25-par preferred stocks in late 1998 and early 1999 when interest rates (and thus capital costs) were low. These preferred stocks quickly became lost cousins when interest rates rose and most investors opted for more speculative issues with higher expected returns. Thus, recently issued preferred stocks that carried 8% and 9% original dividend rates found themselves trading at yields of 12% to 13% during last year’s tax-selling season. Examples included Host Marriott, which owns much of the realty in which the hotel chain operates, and Apartment Investment Management, a REIT whose focus is obvious.

Purchased during distress selling at tax-loss time, these preferreds provided good quality with junk-type yields, plus the prospect of considerable price recovery. Many have since closely approached their original issue prices.

A smaller crop will be available at year-end 2000, since fewer have come to market lately as rates rose. How can you find them? Check the New York Stock Exchange new-lows lists in coming weeks, and look at the convenient separate table of preferred stocks in Investor’s Business Daily. Look for unusually high cash yields where corporate quality risk is not proportionally high.

Preferred stocks are definitely among the most inefficient market opportunities available to individuals. Screenable databases exclude preferred issues, focusing on common stocks. On-line, Web sites carry no news headlines under preferred symbols (when they even do provide charts). Virtually no brokerage firms have analysts who follow and promote preferreds, while many follow junk bonds and all follow common equities. So, you need to do your own homework. You can get the prospectus from the SEC’s EDGAR Web site, or phone the company and ask for one by mail. Also read the traditional print manuals by Moody’s or S&P in your local library. Be sure your are buying a true long-life preferred and not an animal-namesake temporary preferred that eventually becomes common stock at a probable price sacrifice and a certain income loss.

Finding Hidden Value

Value investors, by nature, avoid those areas of the market that are spotlighted by the media and Wall Street. Searching in the dimly lit corners of Wall Street, and in inefficient market niches, can provide those willing to do their homework—and invest patiently—with unusual financial opportunities.
I’ve tried to provide you with some illumination in certain areas that currently are being ignored. Happy hunting.


Donald Cassidy is a frequent speaker nationwide at AAII chapters and SIG groups. His most recent books are “When the Dow Breaks” and “It’s When You SELL that Counts!” His E-mail address is: donald_cassidy@hotmail.com.

© AAII Journal November 2000, Volume XXII, No. 10