1 Closed End Investment Fund Closed End Fund (CEF) establishes a portfolio of securities, then issues shares to the public backed by the underlying securities. Issues shares only once, not continuously Issues shares only once, not continuously Does not redeem shares Does not redeem shares Number of shares relatively fixed Number of shares relatively fixed CEF started to provide liquidity to certain equities CEF trades on organized exchanges, easier for investors to buy and sell

2 Closed End Investment Fund Example of CEF: Brokerage firm determines investment opportunity in growth companies in India Difficult for individuals to invest in Indian firms Difficult for individuals to invest in Indian firms Portfolio manager buys stock traded on local exchanges, registers with SEC, issues shares to public, trades on US organized exchanges Portfolio manager buys stock traded on local exchanges, registers with SEC, issues shares to public, trades on US organized exchanges Shares are issued at an IPO Shares are issued at an IPO At the end of each day fund computes actual value based on closing prices in the local exchange At the end of each day fund computes actual value based on closing prices in the local exchange Wall Street Price Quotes Wall Street Price Quotes

3 Managing a Closed End Investment Fund Bierman and Swaminathan Measures of success of a closed end fund are: Before and after tax return earned by investors Before and after tax return earned by investors Size of the discount (i.e., fund’s market value minus market value of its investment assets) Size of the discount (i.e., fund’s market value minus market value of its investment assets) Smaller discount is assumed to indicate market approval of management’s performance. This study examines the issue whether or not market price discount reflects good or bad management.

4 Managing a Closed End Investment Fund Bierman and Swaminathan Malkiel (1995) - factors responsible for discount - premium: Unrealized capital appreciation Unrealized capital appreciation Restricted Stocks Restricted Stocks Turnover Turnover Distribution (payout) policy Distribution (payout) policy Insider Ownership Insider Ownership Expense ratios Expense ratios

5 Managing a Closed End Investment Fund Bierman and Swaminathan Past record of fund performance Past record of fund performance Proportion of foreign stock ownership Proportion of foreign stock ownership Price level of shares Price level of shares Size of funds Size of funds Investor sentiment about the stock market and the fund. Investor sentiment about the stock market and the fund.

6 Managing a Closed End Investment Fund Bierman and Swaminathan In the absence of taxes and transaction costs, a well managed fund to have small discount and a badly managed fund to have large discount. Question to explore: Do taxes cause closed end fund to sell at discounts? Question to explore: Do taxes cause closed end fund to sell at discounts? If the fund has unrealized capital gains, this reduces the after tax value of the assets compared to the market value of the underlying assets. If the fund has unrealized capital gains, this reduces the after tax value of the assets compared to the market value of the underlying assets.

7 Managing a Closed End Investment Fund Bierman and Swaminathan Example of unrealized capital gains tax effect: 1. Assume the market value = $150; tax basis = $50; capital gains tax rate = 20%; Capital gain = $100. If realized immediately; pay tax ($100x.20) = $20; Value to investor ($150-20) =$130; Capital gain = $100. If realized immediately; pay tax ($100x.20) = $20; Value to investor ($150-20) =$130; Size of the discount ($20/150) = 13.3% Size of the discount ($20/150) = 13.3%

8 Managing a Closed End Investment Fund Bierman and Swaminathan 2. If market value is = $60; tax basis = $50; capital gains tax rate = 20%; Capital gain = $10. If realized immediately; pay tax ($10x.20) = $2; Value to investor ($60-2) =$58; Capital gain = $10. If realized immediately; pay tax ($10x.20) = $2; Value to investor ($60-2) =$58; Size of the discount ($2/60) = 3.33% Size of the discount ($2/60) = 3.33% A seasoned fund with a relatively low investment turnover to have a higher tax discount than a relatively new fund that realizes capital gains rapidly.

9 Managing a Closed End Investment Fund Bierman and Swaminathan The discount also depends on whether the investors expect the fund to sell the appreciated asset. 3. What if the fund does not sell the stock? The fund is worth $150. If the stock is not to be sold, there is no discount for taxes. The fund is worth $150. If the stock is not to be sold, there is no discount for taxes. Therefore, the value of the fund ranges from $130 to $150. The high tax investor may prefer to defer the realization of gains and resulting taxation.

10 Managing a Closed End Investment Fund Bierman and Swaminathan Cost of realized gains: Does the opportunity to buy at a discount outweigh the impact of the capital gains realization and the resulting taxes? Assume that investors have two options: i) Buy a stock worth $150, or ii) consider the following closed end fund - a share of closed end fund=$130; net asset value = $150; tax basis = $50; tax = $20. In addition, fund will realize $17 capital gains every year to perpetuity. At 20% tax rate, the annual capital gains tax = $3.40. Assume that investors have two options: i) Buy a stock worth $150, or ii) consider the following closed end fund - a share of closed end fund=$130; net asset value = $150; tax basis = $50; tax = $20. In addition, fund will realize $17 capital gains every year to perpetuity. At 20% tax rate, the annual capital gains tax = $3.40.

11 Managing a Closed End Investment Fund Bierman and Swaminathan TimeCash Flow 0 +$20Discount Incremental capital gains tax Consider the cost of borrowing ($20) is 17% Consider the cost of borrowing ($20) is 17% Decision to invest in the fund or the underlying stock: Decision to invest in the fund or the underlying stock: If cost of borrowing < 17% : buy stock If cost of borrowing < 17% : buy stock If cost of borrowing > 17% : buy fund If cost of borrowing > 17% : buy fund

12 Managing a Closed End Investment Fund Bierman and Swaminathan The amount of discount, considering the tax effects, depends on: The tax basis The tax basis The tax rate The tax rate Expected growth rate in stock price Expected growth rate in stock price Time horizon Time horizon Relative importance of dividends and capital gains Relative importance of dividends and capital gains The discount rate The discount rate

13 Managing a Closed End Investment Fund Bierman and Swaminathan In summary, management of a closed end fund wants to maximize the after tax return to its investors. In summary, management of a closed end fund wants to maximize the after tax return to its investors. A tax sensitive fund management will face an increasing discount as the fund ages and capital gains accumulate. A tax sensitive fund management will face an increasing discount as the fund ages and capital gains accumulate. The value of the fund with unrealized capital gains will be less than the market value of the fund’s investments. The value of the fund with unrealized capital gains will be less than the market value of the fund’s investments.

14 Managing a Closed End Investment Fund Bierman and Swaminathan From the tax perspective of the current investors, the fund should not realize capital gains; prospective investors, due to unrealized capital gains, will reduce the fund’s market value to below NAV. From the tax perspective of the current investors, the fund should not realize capital gains; prospective investors, due to unrealized capital gains, will reduce the fund’s market value to below NAV. How to reconcile this difference - Establish a policy of not realizing capital gains for ‘n’ (defined) period and attract investors with n period planning horizon. How to reconcile this difference - Establish a policy of not realizing capital gains for ‘n’ (defined) period and attract investors with n period planning horizon. Discount does not imply that management has failed to manage a closed end fund properly. Discount does not imply that management has failed to manage a closed end fund properly.