Go to the Globe and Mail homepage

Jump to main navigationJump to main content



Attention, suckers: Closed-end funds Add to ...

Dear client: After giving much thought to your interests, in particular how they can be moulded to further mine, here's what I'm thinking: You're going to give me $12,000 to invest on your behalf. I will immediately turn that into less by giving my friends and allies as much as $810 of it.

Then I'll probably ask you for another $12,000. If you give it to me I'll turn it into less again. And if you don't give it to me, I'll give some of your wealth to someone else.

Don't thank me yet because there's more. I'm going to put what's left of your money in stocks that pay dividends and I'm ready to (almost) promise you a 7-per-cent yield.

How I'll generate that generous yield, given that I'll likely be charging about two percentage points every year in fees, is subject to debate. But borrowing money to buy more stocks is definitely one way. You have to pay the interest costs of course.

If you think no invitation to invest could be quite like this, guess again. This is my simple-language translation of a typical prospectus for a closed-end fund - in this case, the GM Income Growth Fund being flogged by Middlefield Capital Corp. and a legion of investment banks.

Like all prospectuses, the one for this fund will go unread by the people who buy the fund, so let me summarize it for you: You'll know you're a sucker if you invest.

While Middlefield is only the latest fund of this type to roll off the assembly line, there are many like it. The way these funds turn your money into less money is through fees, specifically the cost of feeding all those bankers, brokers and lawyers who toil to put the deals together. If this fund raises $100-million, they'll collectively earn more than $6-million of your money - "earn" being defined loosely in this case.

Then the managers will get to work in exchange for a couple of million or so a year. This is to pay themselves and the other costs of running the funds, like trading commissions. In the case of Middlefield, just to get your asset base back to break-even, and pay the target distribution, these managers would have to make more than 15 per cent in the first year.

Middlefield CEO Dean Orrico told me that it is feasible for the fund to achieve its target distribution and pay back all the financing fees within 18 months given what he sees as the number of quality real estate and oil and gas trusts out there. Count me among the skeptics. Who can reliably generate 15-per-cent returns when risk-free government debt is barely yielding 2 per cent?

Another thing to think about is the warrants that come with each unit of this beast. A unit costs $12 and gives you one share and the right for a year to buy another for $12. Naturally, the shares would have to be trading for more than $12 to make it worth your while to exercise the warrant. But if they are, you'll think you're getting a bargain. You're not. Warrants add zero value - except to the people who sell funds.

How Warrants Work

Let me illustrate: think of a fund with two investors, you and me. It's worth $100,000 and we each have a share worth $50,000. If we also have warrants that let us buy another share for $40,000, and we use those warrants, the fund is now worth $180,000 and we each have two shares worth $90,000. Unless you failed grade-school math you know you're not better off. There's no value created; only the illusion of having gotten something for less than it's worth.

If, on the other hand, I exercise my warrant and you don't, I now have two shares of a fund worth $140,000 and you have one. I'm ahead because you didn't exercise.

Mr. Orrico's response is that the warrants, which will trade, have value. Yes, but as the math above demonstrates, that value comes out of investors' hides.

It's actually worse than that because if you exercise a warrant from the Middlefield fund - and this is typical of such funds - your broker and his firm get another 2.5 per cent of your money.

What do they do to deserve these rich fees? That's a question in search of an answer. But the manager is happy to see warrants exercised because he'll be managing more assets and earning more fees.

On a final note, this fund will target a 7-per-cent yield, and that's after fees so it needs to generate 9 per cent or so to pay you 7. There are no quality stocks yielding more than 9 per cent, although the fund says it'll use debt to lower that hurdle to 8.2 per cent.

Mr. Orrico insisted to me that his fund is a sound investment. He believes there are enough companies offering enough yield that the target is achievable, given the use of enough leverage. I disagree.

Fabrice Taylor is a Chartered Financial Analyst.

Report Typo/Error

Follow us on Twitter: @GlobeInvestor



Next story




Most popular videos »

More from The Globe and Mail

Most popular