The Disaster of Closed-End Mutual Fund IPOs

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There are many things to protest about Wall Street. Unfortunately the crowd currently gathered there doesn’t a have a clue about economics. Bret Arends certainly does. His latest article for MarketWatch, “How Wall Street scammed Mom and Pop — again” explains the folly of investing in closed-end mutual fund IPOs:

When you invest in the IPO of a new fund, the first 5% of your money typically goes straight into the pocket of the brokers selling the fund. Brokers love these IPOs. The effective commission is huge. They make a mint.

So if you buy into a new fund at $20 a share, the broker pockets $1. So already the underlying net asset value of your shares is down to $19 — before the fund has even begun operation!

The second thing investors don’t realize? Shares in these funds typically end up trading on the stock exchange for less than their net asset value.

In other words, while new investors are handing over $20 per share for a stock only worth $19, there was probably a nearly identical fund on the exchange that they could have bought for maybe $17 a share.

Why didn’t the broker recommend the $17 share instead of the $20 share? Gee, I don’t know, but I guess I should mention that on the $17 share he doesn’t get that juicy $1 fee.

The third thing investors don’t realize? Wall Street typically hustles these funds at, or near, the peak of the market. That’s when it’s easiest to sell them. When Wall Street sells you an emerging market closed-end fund, it means there is a lot of appetite out there for emerging markets. That’s usually a sign that emerging markets are getting too warm.

Oh, and one more thing investors typically don’t realize: These fund shares are incredibly volatile. In a market panic, that fund’s $19 in net assets may fall to, say, $15. But the shares, which you bought for $20, will probably plummet to $12 or even lower.

Closed-end funds, as a general rule, are a great buy in a panic — and a terrible buy in the IPO. Wall Street likes to sell you the opposite story — for obvious reasons.

If you are making a list of things you should run from, add closed-end IPOs and commissioned brokers.

Consider a fiduciary fee-only NAPFA advisor instead.

Follow David John Marotta:

President, CFP®, AIF®, AAMS®

David John Marotta is the Founder and President of Marotta Wealth Management. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. In addition to his financial writing, David is a co-author of The Haunting of Bob Cratchit.