The Glove and Mail, Report on Business
Published April 28, 2007

I get grouchy when I see products being offered that are just plain bad for investors.  I've been grouchy a lot lately, particularly with all the high-fee, principal-protected products that are coming out.  My wife and business partners tell me I have to focus on more positive things, but when I see a product like the one that Claymore Investments is currently offering, I feel compelled to comment.

Claymore is selling a closed-end fund called the Claymore Equal Weight Banc and Lifeco Trust.  The fund is pretty simple.  It will own 10 stocks - 6 banks and 4 insurers.  The stocks are equally weighted and rebalanced twice a year. 

The fund will endeavour to pay out a 5% distribution, which is well above the income generated from stock dividends.  So, while some of the distribution will come from dividends, most of it will be a return of capital.  The latter is paid out in anticipation that the portfolio will appreciate over time and dividends will grow.  In effect, the fund is converting an equity portfolio into an income product by turning the variable and unpredictable price performance of the stocks into predictable, monthly distributions.

This strategy of 'pre-paying' the anticipated capital appreciation beats a lot of other methods being used to generate 'bond plus' yields.  It only makes sense, however, if it is based on a balanced, well-diversified portfolio.  Basing it on 10 stocks in the same industry is quite a different matter.

I say that because products like this are path dependent. 

First of all, the underlying assumption here is that financial stocks will provide an annual total return greater than 5%, let's call it X%.  If the stocks go up after the issue closes, everything should be fine and the distributions will be secure.  But if, on their way to that X% return, the stocks take a downward path first, sustaining the 5% distribution rate may be difficult to do. 

That's because the fund must sell shares to pay distributions.  If the stocks are down for the first couple of years, the fund will have to sell more shares and will have less capital at work when the stocks turnaround and head north.  Looking at the charts of the 10 stocks in the fund, it's hard to see how they could ever go down.  But financial stocks do go down or they can sit dormant for a number of years.

This fund is more conservative than some path dependent products that went bad in the past.  I'm referring to some of the 'covered-call writing' funds (also called hybrid income funds), which had more aggressive assumptions built in.  When the bear market hit at the beginning of this decade, these funds didn't have the capital required to fund their distributions.  In the Claymore case, it would appear there is some cushion built in. 

If you are a buyer of this or any other initial offering of a closed-end fund, you should know that for every $100 you put in, about $93 will be invested.  That's because all underwriting and sales commissions are paid by the fund before the investments are made.  Essentially, you are paying for the startup of the fund. 

The Claymore offering has a unique feature that has garnered some attention from other industry players.  Closed-end funds aren't as easily traded as mutual funds.  As a result, investors usually have to sell in the after market at a discount to net asset value (NAV).  After six months, if the Claymore fund trades at a price that is more than 2% below its NAV for 10 consecutive days, it will automatically convert into an exchange-traded fund (ETF).

This feature seems to make sense given the simplicity of the fund.  For the unitholder, the discount disappears and for Claymore, they can grow the fund.  There is a hitch however.  If the fund converts to an ETF, the fee goes up.  Initially, the fund will have a fee of 0.85%, which is made up of a 0.55% management fee and 0.30% service fee which goes to the selling broker.  A fee of 0.85% for acquiring and re-balancing 10 of the most liquid stocks in Canada seems high enough, but after conversion it goes up to 1.25%.

This Claymore fund is an example of how closed-end funds are being overused today.  A closed-end fund is appropriate when there is a high expertise quotient; leverage is used as part of the investment strategy; the fund invests in illiquid assets that are inappropriate for an open-end fund; and/or the fund is amenable to a split share structure.  This product has none of those elements.  Indeed, a novice investor could put this strategy in place at a fraction of the cost.  By offering a future ETF as a closed-end fund, the issuer gets the initial investors to pay for the launch and help build a critical mass of assets. 

If this product is appropriate for anybody, it would be the small investor who can't buy 100 shares in 10 high-priced stocks.  My advice to those small investors, however, is to wait until the end of the year.  As an ETF, there will be a share class offered with a much lower fee and the big guys will have paid all the startup costs.