Fabrice Taylor, Chartered Financial Analyst, is a principal in Capital Ideas Research and writes the blog fabricetaylor.com
There are countless ways to give yourself a self-inflicted wound in the stock market. The easiest is to buy a freshly minted closed-end fund, those little financial free radicals that do nothing but permanent damage.
A closed-end fund is sort of like a mutual fund in that it sells units - in this case shares - to the public and uses the money to buy stocks or other assets. The difference is that the price of a mutual fund unit is always equal to its share of the pool of assets.
So if a mutual fund has 100 units outstanding and the value of its portfolio of stocks is $1,000, each unit has a net asset value of $10 and is redeemable for that much.
A listed closed-end fund is similar but it trades on the stock market. And because it trades, the price of a share can vary from the share's net asset value. In fact, not only does the cost of the IPO erode the investment before it even starts trading, but the shares will almost always trade at a discount to that eroded value. IPO investors take it on the chin in two ways.
So the question is: if you're an investor, why would you ever buy one in an IPO? If you're a broker, why would you ever sell one to a client?
Let's look at a couple of examples: The BMO-sponsored Coxe Commodity Strategy Fund was launched in 2008 at $10 a unit. Within weeks it was worth half of that.
You can blame bad timing for most of the drop in value but make no mistake, the odds were stacked against investors.
The units were sold for $10 a piece. But after all the quacking ducks were fed - the investment bankers, the brokers, the lawyers, the accountants - the units were worth about $9.40.
So you're already down about 6 points. But don't think too hard yet because it actually gets worse if you're an investor. The management fee is 1.55 per cent per year. Then there's a service fee of 0.4 per cent a year payable to the broker who sold you the fund.
The manager will have to earn about 8 per cent in the first year for you to just break even. Stunning isn't it?
There's even more. Each unit of this fund you buy comes with a warrant that lets you buy another unit later, ostensibly at a cheap price. That sure sounds like a deal right? Right! For the investment banks and for the brokers! It's a categorical rip-off for you the investor.
Warrants do nothing for you. They don't add to your wealth because you're just buying more of the same fund. It doesn't matter that you're buying stock for less than the market price because you're buying it from yourself.
But if you don't exercise the warrants, someone else can and you get diluted, meaning you lose. So the best you can do with warrants is not lose.
(The warrants may never get exercised in this case but the point is made.) But the "agents" - the brokers and their firms - win, because the fund pays a fee of 25 cents per warrant exercised. More dilution. By my math, the manager could have to earn more than 10 per cent in the first year just to get you back to zero.
But there's even more. Closed-end funds like these almost always trade at a discount to their net asset value, and the Coxe fund is not an exception. At last count, it was more than 7 per cent.
Not even a celebrity like Don Coxe, a BMO strategist and a great finance writer, can solve the arithmetic working against investors. And he's not alone. The same fate befell investors who entrusted their money to Dennis Gartman, whose Horizon AlphaPro Gartman ETF has been a major disappointment. Launched a year ago, when stocks hit their lows, it's down. It hasn't even kept pace with its absurdly low benchmark, one-year Canadian T-Bills.
The ETF is actually shrinking, with the share count down by 25 per cent or so - that's unheard of for an ETF like this, in my experience.
(One investor that hasn't ditched the stock, interestingly, is the Horizons Global Contrarian vehicle, which has 13 per cent of its assets invested in its sister fund.) The good news is that the Gartman fund's discount to NAV has closed, for now at least.
Closed-end funds can be great investments after the IPO, when they've sunk to a fat discount. You rarely lose when you buy dollars for, say, 75 cents. Just never buy them on an IPO.