The Hindu Business Line : Exchange-traded interval fund: Lowering close-end discount, open-end cash drag

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Exchange-traded interval fund: Lowering close-end discount, open-end cash drag

Listing close-end funds provides greater flexibility to investors than offering a periodical redemption window.

B. Venkatesh

Recent reports suggest that SEBI is revising rules to make it mandatory for all close-end funds to list on the stock exchange.

This follows the recent redemption pressure that close-end funds faced due to large withdrawals by institutional investors.

Listing of close-end funds is more efficient than providing periodic redemption windows as is offered at present.

A new structure, styled as “exchange-traded interval fund” that draws on the advantages of close-end fund and exchange-traded fund, may help reduce the exit cost for investors.

Discount, cash drag and ETFs

Some close-end funds provide periodic redemption windows to investors. Other close-end funds list on the stock exchange to provide unit-holders an exit route during the funds’ life.

Listing close-end funds, as SEBI proposes to do, is more optimal than providing periodic redemption windows, as it offers greater flexibility to investors. The problem, however, is that listed close-end funds typically trade at a discount to their net asset value (NAV).

Suffice it to know here that it is termed “close-end discount puzzle” because there is still a debate on why the discount exists.

Open-end funds, on the other hand, suffer from the problem of cash drag. Such funds are forced to hold cash equivalents to meet daily redemption requests from unit-holders.

But this results in lower returns as cash equivalents earn less when compared with other assets such as stocks and bonds in the fund’s portfolio.

Exchange-traded funds (ETFs) were developed to obviate the problems of the close-end discount as well as the cash drag on open-end funds.

An ETF, like a close-end fund, is listed on the stock exchange. But unlike a close-end fund, it does not trade at a substantial discount to the NAV.

The reason is that qualified institutional investors in the fund are permitted to arbitrage the price difference.

ETFs are, however, passive investments on tradable indices whereas close-end funds are actively traded. Can the ETF structure be imported to lower the close-end discount?

Exchange-traded interval funds

Interval funds allow unit-holders to purchase and redeem units, say, once every quarter or during a week every half year.

There are two problems with such funds. One, investors do not have exit opportunities between the interval dates.

And two, the fund manager is forced to rebalance the portfolio during the interval windows to provide for redemption requests. The cash drag still exists though it is lower than for open-end funds.

How about an exchange-traded structure with periodic redemption windows?

Take HDFC Mid-cap Opportunities Fund. This is a close-end fund that allows redemption requests during a specified period each quarter.

Suppose this fund were listed on the exchange. It would typically trade at a discount to its NAV.

Assume that qualified institutional participants are allowed to arbitrage the NAV- market-price difference during specified periods.

This can be done in two ways. One, when the fund trades at a discount to the NAV, the qualified investors can buy units from the market and redeem them with the asset management firm for underlying shares, not cash. Two, when the fund trades at a premium to the NAV, the qualified investors can buy the underlying shares, deliver them to the asset management firm and receive equivalent units.

This process arbitrages the difference between the fund price and its NAV, essentially reducing the exit cost for investors.

The close-end fund is essentially then an ETF with a difference.

As ETFs are on some tradable index, the portfolio is always known. The portfolios of active funds, on the other hand, change frequently. Such funds cannot, hence, offer continual arbitrage opportunities to the qualified institutional investors due to operational difficulties.

These funds can, however, allow specified windows each week or fortnight (or intervals) to enable the institutional participants to arbitrage away the price difference.

As this structure resembles ETFs more than close-end funds, we prefer to call it “exchange-traded interval funds”.

What if?

An exchange-traded interval fund can, thus, reduce the close-end discount as well as eliminate the cash drag suffered by open-end funds.

So, why not offer new funds through such structures? Would asset management firms take such an initiative?

There has to be a paradigm shift in the business policy of asset management firms; for these firms typically generate revenue as a percentage of assets managed.

An open-end fund structure helps these firms generate higher revenue, as investors can purchase new units without any restriction.

A well-performing exchange-traded interval fund, on the other hand, will not enable asset management firms to generate higher revenue, as the fund cannot offer new units after the initial subscription period.

Firms can, however, build credibility among investors offering such investor-friendly products.

And that could stand the asset management firms in good stead over the long term.

(The author is an investment strategist. He can be reached at enhancek@gmail.com)