Canny Money Manager Spots Prey: the Undervalued Closed-End Fund

ANNAPOLIS, Md. — It seems an odd place to plot the next wave of hostile takeovers.

But there in his airy Annapolis living room overlooking the calm waters of Crab Creek, Bob Gordon speaks of financial war. His prey: the investment companies known as closed-end mutual funds whose undervalued shares offer opportunities for short-term trading profits.

Gordon, a 35-year-old money manager who splits his time between Annapolis and Manhattan, is remarkably candid about potential takeover targets. “Scudder New Asia Fund is an obvious one to go after,” Gordon said. “Scudder gave in on one before.”

Identifying profit-making opportunities with relatively low risk is Gordon’s specialty--and he pursues it day and night. With his fiancee sleeping nearby, Gordon regularly studies the tax code and other documents until 2 a.m., dreaming up new ways for clients of his New York-based Twenty-First Securities Corp. to boost after-tax returns.

“I see little glitches,” he said. “When I was 12, I knew I wanted to do this. I like math, and this is a practical application of math. It is fun for me.”

Gordon believes that he has identified a glitch in closed-end funds that makes them vulnerable to a hostile raid.

Unlike the more common open-end funds, a closed-end fund sells a fixed number of shares to the public and invests the proceeds in stocks and bonds.

Price Reflects Value

In open-end funds, investors buy their stake from the fund and sell it back whenever they wish. There is no limit on the number of shares, and the price reflects the exact value (net asset value) of the stocks, bonds or cash held by the fund at the time of a transaction.

Closed-end funds are more like industrial firms whose shares trade on stock exchanges--the price for a fund’s shares is primarily determined by the demand for the fixed number of shares. Investors consider the underlying market value of a fund’s holdings, but share prices for the funds are also influenced by expectations, emotions and other factors that often affect prices in the stock market.

Many of the closed-end funds are vulnerable to a takeover maneuver these days because the shares of these funds are trading at discounts of 20% or more below the market value of their holdings. The Securities and Exchange Commission recently launched a study to determine why these discounts exist.

To their horror, uninformed investors often find that shares in new closed-end funds quickly drop below their initial offering price and may continue to remain significantly below the market value of the fund’s holdings.

There are several reasons.

First, the initial price includes substantial underwriting fees paid to the brokerage firms that market the shares.

Second, while these brokerages may support the price through active trading in the days immediately following the offering, the firms typically retreat soon after and use their capital elsewhere. Once the firms are no longer supporting the price of a closed-end fund, it typically drops.

High Management Fees

Another common factor affecting prices of closed-end funds are high management fees, which reduce returns, said Thomas J. Herzfeld, a Florida-based closed-end fund expert who is working with Gordon on possible plans to restructure closed-end funds.

What Gordon has in mind is the forced conversion of publicly traded closed-end funds to open-end mutual funds, or, in extreme cases, the forced liquidation of closed-end funds.

Gordon speaks of buying shares in a closed-end fund, presenting a restructuring proposal to fund managers and then giving the managers a severe “this is your one chance to save your jobs” warning. “Some of the guys are waiting for it to happen to them,” Gordon said.

Although these strategies are not risk-free, they could produce stock trading profits for Gordon and other closed-end fund investors.

The conversion of an undervalued closed-end fund to the open-end variety creates the profits, according to Gordon’s strategy. By definition, an open-end mutual fund trades at a price that reflects the market value of its holdings. So the price of an undervalued closed-end fund will rise if the fund is converted to an open-end fund.

Closed-end fund managers may oppose conversion for several reasons. First, they receive a management fee that is a percentage of total fund assets. After a fund is converted to open-end and the price rises, Herzfeld said, many fund investors typically sell, shrinking assets under management and management fees by one-third.

Fund managers may also oppose conversion because of a belief that an open-end structure--which requires them to redeem investor shares on demand in cash--will hurt the fund in the long run.

Criticism of Tactic

Nick Bratt, president of the Scudder New Asia Fund--mentioned as a possible target by Gordon--said that an open-end structure could hurt the fund in the long run by forcing it to raise cash by dumping stocks of small, growing companies at inopportune moments.

“I would argue quite vehemently that the particular nature of the Scudder New Asia Fund would not make it a sensible candidate for opening up,” Bratt said. Bratt acknowledged that conversion to open end would increase the New Asia Fund share price in the short term.

“I can’t deny eliminating the discount overnight would generate shareholders’ wealth in the short term,” he said. “But the price of doing that would be to put at risk the long-term interests of shareholders.” Bratt described the fund’s 20% discount to the market value of its holdings as “unfortunate.”

Under pressure from a group that included T. Boone Pickens III, the son of the Amarillo-based oilman and corporate raider, Scudder last year converted its closed-end Japan Fund to open end. Bratt pointed out that Scudder’s Korea Fund is one of the few closed-end funds trading at a premium price--above the market value of its holdings--citing it as an example of how specialized closed-end funds can sometimes perform in a superior fashion.

High legal fees and takeover defenses could complicate Gordon’s plans. But David Schafer, president of Schafer Capital Management Inc., which manages the Schafer Value Trust identified by Gordon as another possible closed-end target, said he would be willing to discuss a sensible proposal.

“I am not sure what I would do,” Schafer said. “I would have to see what sort of a proposal it was. Certainly the shareholders would be the ones who would ultimately determine” the outcome.

Although some question the profit potential in these takeovers, partly because of potentially costly opposition from management, Gordon is confident that either he or others considering closed-end fund restructurings will succeed. “It is an opportunity just waiting to happen,” he said.

Returns for Clients

This concept has been profitably applied in earlier periods by well-known corporate takeover artists, including some of the principals of Coniston Partners, who then went on to stalk bigger game.

For Gordon, closed-end fund takeovers would be another way to generate returns for clients of his Twenty-First Securities money management firm. He already manages hundreds of millions of dollars of cash for corporate clients in programs designed to take advantage of stocks that pay high dividends and other market strategies.

After attending Yale University and the University of Connecticut--neither for more than a few days before boredom set in--Gordon started in the investment business as a broker in Washington for Laidlaw Adams & Peck in the 1970s. “I could have stayed there and taken over the firm someday,” Gordon said.

Instead, after about five years in Washington, he went on to become a partner and trading specialist at the Oppenheimer firm in New York, before venturing out on his own after concluding that he had little chance to run that firm.

Gordon said that while his Twenty-First Securities office in mid-town Manhattan is only “86 steps” from his apartment, he hopes to begin spending more time in his new Annapolis home on Crab Creek, despite the longer commute.

Gordon manages some funds in conjunction with longtime Wall Street stock market analyst Robert Stovall and is described by Stovall and others who know him well as possessing an unusual combination of sales and technical skills. And while most Wall Street professionals shun policy-making in Washington, Gordon seems to enjoy talking regularly with everyone from the chief economist of the SEC to Capitol Hill staff members.

He is neither shy nor modest, and while some of his stories and statements appear to be exaggerated upon further reporting, Gordon enjoys a solid reputation among clients and colleagues.

Consistent Performance

That reputation for consistency (a return of 7% to 10% after taxes) rather than spectacular performance in his dividend fund was enhanced last October when the stock market collapsed. The fund makes use of a variety of techniques to minimize risk in a market decline, and these “hedging” strategies prevented investor losses despite the record market plunge, Gordon said.

Gordon, whose father is a nuclear industry consultant in Rockville, Md., boasts that he has “never paid tax” because “I always reinvest my profits in a new business.”

As he amasses a personal fortune, Gordon described his ongoing professional challenge as finding transactions that are secure enough for clients and risky enough to be considered legitimate by the Internal Revenue Service.