The 1929 Closed End Fund Mania(ZT)

Sunday, February 04, 2007

The 1929 Closed End Fund Mania

In 1929, there was a closed end fund mania that rivalled the internet dot-com mania of the late 1990’s. Most closed-end funds in 1929 sold at large premiums over NAV. Most “experts” at the time thought this was justified - the fund managers’ superior ability to pick stocks was thought to multiply the value of the fund by 1.5 or more. (Hmm, sounds like the justification used for paying high fees for hedge funds today). Here is an excerpt from the “Magazine of Wall Street”with recommended guidelines for selecting closed end funds (published September 21, 1929):

“Shares of an investment company capitalized with common stock only and earning 10 percent net on invested capital might be fairly priced at 40 to 50 percent in excess of liquidating value. If the past record of management indicates that it can average 20 percent or more on its funds, a price of 150 percent to 200 percent above liquidating value might be reasonable… To evaluate an investment trust common stock, preceded by bonds or preferred stock, a simple rule is to add 30 percent to 100 percent, or more, depending upon one’s estimate of the management’s worth, to the liquidating value of the investment company’s total assets.”

Here are some amazing statistics about closed end funds during the 1928-1930 time period:

1) The median closed-end fund premium in the 3rd quarter of 1929 was 47 percent. By the summer of 1930, the median closed-end fund sold at a 25 percent discount. This negative 72 percent swing added to the 12 percent negative return in NAV resulted in a near wipeout in the market value of these funds.

2) There was a huge issuance of closed end funds in the 3rd quarter of 1929- about 1 billion in the two months of August and September alone. This is equivalent to about 10 billion in purchasing power today, and about 60 billion relative to the size of the US economy.

3) Closed end funds completely dominated new stock issuance in the summer and early fall of 1929. In June and July, ALL new equity issues were closed end funds. The over-pricing of closed end fund crowded out individual stock issues during this period.

4) During the early 1920’s, closed end fund promoters rarely disclosed their holdings. They argued that a closed-end fund has tangible assets (it’s portfolio) plus intangible assets (the skills of its managers). They argued that if a fund revealed its portfolio, other investors could “free-load” and copy the fund’s portfolio and avoid paying the management fee. They looked at a fund’s portfolio as a trade secret. (Again, note the similarity to today’s hedge funds). This attitude changed after the 1929 crash, when closed end funds did start to disclose their holdings to make it clear that their fund was still solvent and their holdings were selling at a discount to NAV. The discounts to NAV that developed in 1930 were considered extremely abnormal and was very puzzling to the pundits of the time.

5) Here is some data on some individual closed end fund premiums taken from a research paper by De Long and Shleifer:
-Investor’s Equity Co. +166% premium (late 1928)
-General American Investors +233% premium (early 1929)
-Capital Administration Co. +1235% premium (early 1929)
-US & Intl Secur. Corp. +212% premium (June 1929)
-Investor’s Equity Co. +276% premium (July 1929)

The Goldman Sachs Trading Company deserves special mention. Goldman Sachs was the largest promoter of closed end funds during the 1928-1929 time period. Goldman Sachs partner Sydney Weinberg, when asked why his company had formed so many closed end funds, replied- “Well, the people want them”.

In December1928, Goldman Sachs formed the Goldman Sachs Trading Company but retained enough common stock to keep control. In the summer of 1929, it launched the Shenandoah Corporation. Goldman Sachs held most of the common stock in Shenandoah and sold common/preferred stock to the public. This established a fund of funds with leverage.

The Shenandoah Corporation then set up the Blue Ridge Corporation, holding most of the common stock itself and selling common/preferred stock to the public. This established a fund of fund of funds with leverage at two levels. Any gain in Blue Ridge would be passed on to Shenandoah with leverage, and these gains would be further magnified as they flowed back to Goldman Sachs Trading.

The Blue Ridge Corp sold at a 46% premium in August 1929, but fell to a discount of 24.5% by 1930. The Shenandoah Corp sold at a 103% premium when it first came out as a new issue in 1929. Goldman Sachs discovered that leverage is a two way street and the Goldman Sachs Trading Corporation stock collapsed from its high point of $280 a share in 1929 to $1.25 in 1932.
If anyone is interested, you can purchase a beautiful engraved cerificate of the Blue Ridge Corporation from scripophily.com. It was issued in 1930 and costs $69.95. I wonder if any Goldman Sachs employees have this certificate hanging on their office walls.