Let’s continue to discuss the current sub-prime mess and review the characteristics of open-end funds and closed-end funds in the CFA exam (Alternative Investments).

Due to the sub-prime mess, there are two important consequences in the headlines. Last week, BNP Paribas SA in France said that it would block redemptions of their shares to prevent selling their assets into the market for far below the fair values. And today, in US, Sentinel Management Group, also announced the same decision. Because of this, the Dow Jones Industrial Average closed at more than 200 points lower, among other bad news such as Wal-Mart Stores and Home Depot disclosing a tougher retail environment.

Why did BNP Paribas SA and Sentinel Management Group have to block redemption?

First of all, a fund is formed when the investment company gathers the money from investors and uses them to buy assets (securities, bonds etc). For example, if there are 1000 investors and each pay $1000, this will form a $1 million fund. A fund manager will be hired to manage the $1 million by buying securities or other financial instruments (and hopefully they will appreciate).

The fund can be closed-end or open-end (in US, it is also called mutual fund). For a closed-end fund, the number of share is fixed. For example, each of the 1000 investors may be holding 1 share of the fund. So each share is $1000. If someone wants to join the fund, he has to buy the share from these investors. So, closed-end funds are traded in the secondary market (e.g. NYSE) just like other regular stocks. Holding a closed-end fund share is just like holding a normal stock of the fund company (except that the fund company has no product but just buying other financial instruments and earns profits when the assets appreciate). Similarly, if one wants to quit the fund, one can just sell his share in the secondary market.

The other type of fund is the open-end fund. BNP Paribas SA is an open-end fund. In an open-end fund, the number of share is not fixed. If one wants to join, he can let the investment company know and the company will create an additional share for him! For example, one can invest $2000 and 2 additional shares will be created. The investment company will then use the $2000 to buy more financial assets. Similarly, if one wants to quit the fund, he cannot sell his shares in the secondary market. Instead, the fund manager will sell some of the fund assets and pay the share owner $1000 for a share. The total number of share of the fund will then be reduced. This process is called redemption.

Now, let’s say you own some shares of BNP Paribas SA. You heard that this fund has assets including MBS and some are related to sub-prime mortgage. Due to the credit crisis, you have no faith anymore. So you decided to redeem the shares. The fund manager in BNP Paribas SA has to give you the money back based on the fair value of the share. In order to get the money, he has to sell the assets as soon as possible. Among the assets, there are some high graded assets (e.g. blue chip stocks) which have very high liquidity. And some have very low liquidity (e.g. MBS in this case). He has no choice but to sell all the high graded assets first in order to give you the money back (he just can’t sell MBS because no one wants to buy at this moment!). As a result, as more people redeem their shares, the high graded assets and high growth-rate assets will be sold (and can be at prices below the fair values) while those low liquidity ones are kept. So the total fund asset value will drop substantially. And more and more assets have to be sold at prices much lower than the fair values!

In order to prevent this, they choose to block redemption and only resume when the market is recovered from the irrational response to the sub-prime mess.

While for closed-end fund, although the value per share will also dropped (due to the demand and supply relationship in the secondary market), they can be recovered automatically once the crisis is gone. No asset selling is required (so no permanent loss) for the fund manager. Therefore, closed-end fund is at a better shape than the open-end fund in this crisis.

Finally, you should know how to calculate the Net Asset Value (NAV) of a fund. NAV is the value per share.

NAV = (total asset – liabilities) / total number of shares