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fabrice taylor

As far as stocks go, Canadian General Investments looks like a rock star, up roughly 50 per cent year to date, much better than the broader market.

But looks are often deceiving. Canadian General is a closed-end fund. The value of its portfolio - its net asset value - is up only 22 per cent since the start of the year (to the end of August).

That tells me that Canadian General's shares were especially cheap around Jan. 1, most likely because of massive tax-loss selling at the end of 2008.

Canadian General has been around for a long time. It's not a particularly good or bad fund. The stock market, as of Aug. 31, was down 18 per cent. Canadian General's shares were down 33 per cent and its net asset value was down a little more. Few actively managed funds have matched the market or even come close.

Still, I can't help wondering, and I'm sure Canadian General's shareholders must wonder too, how the fund would have done had it bought back its own stock. Shareholders would be justified, in my view, in wondering if it has to do with the fact that the managers of these kinds of funds - Canadian General is by no means alone - have an inevitable appearance of a conflict of interest.

The value of Canadian General's shares is more than 20 per cent lower than the value of its portfolio. If you can buy $1 for 80 cents, in a rational world, you're basically guaranteed a 20-per-cent return because discounts shouldn't persist. I don't think Canadian General's investment brain trust, Morgan Meighen and Associates (MMA), sees many investments that guarantee that kind of return.

So why don't they do it? I asked CEO Jonathan Morgan. He offered a few reasons - dividends are better, tax complications, it doesn't necessarily work etc. - none of which I found especially convincing.

Shareholders would be forgiven for thinking that perhaps the real reason is that people always do what their incentives tell them to do, and MMA has no interest in buying back stock, even if it's a no-brainer for investors. Why? According to the latest annual report, MMA takes a management fee of 1.7 per cent.

That fee is applied to the net asset value of the portfolio. Buying back stock means reducing the net assets, and reducing the fees, which in 2008 ran to almost $5-million. Mr. Morgan argues that he and his sister own half the stock so their interests are aligned with shareholders. That's not entirely correct because other shareholders don't collect management fees.

As I said, Canadian General is not alone by any means. The Ceres Global Agriculture Corp. is not a closed-end fund but it operates in a similar way. The manager is Front Street Capital, which charges a fee of around 2 per cent. Ceres raised $150-million a couple of years ago with a mandate to start off by investing in the securities of agriculture-related companies, or buying them entirely, and to eventually become an operator. Sounds ambitious, which may explain why the shares trade at a persistent discount to the portfolio, like Canadian General.

Ceres announced a buyback of stock in June, when the discount was about 30 points. It's still around the same, and Ceres hasn't bought back much stock at all. Was it because it would reduce the manager's fees?

Ceres' chief financial officer, Jason Gould, told me the company has a board of directors, which is supposed to look after the shareholders. He acknowledged the potential for conflict of interest but was adamant that it would be checked by independents on the board.

But, to use an extreme scenario, liquidating the portfolio and giving investors their money back would give all investors a huge return over what their shares are trading for now. The principals of Front Street are probably the biggest shareholders.

The directors, independent on paper, should be adamant on at least fulfilling the announced buyback. But, then there's those fees, running at a couple of million bucks a year. It's easy to sympathize.

And again, I stress, the same goes for most closed-end funds and similar vehicles. They are fraught with potential conflicts of interest, and when managers' interests compete with shareholders', there is temptation. That's just human nature.

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