Key Idea
The First Trust Dynamic Europe Equity Income Fund (NYSE:FDEU) is an equity closed-end fund that aims for high current income, with capital appreciation as a secondary objective. This fund primarily invests at least 80% of its assets in European stocks, with a focus on large capitalization companies. FDEU functions as a tool for generating a high dividend yield from European equities.
FDEU is one of the few closed-end funds undergoing conversion to become an exchange-traded fund (ETF). This has implications for existing shareholders, who should be well-informed about the corporate action and its consequences. Understanding the differences between CEFs and ETFs is crucial for retail investors to make an appropriate decision based on their needs and preferences.
Conversion from CEF to ETF: An Interesting Move
The conversion of FDEU from a closed-end fund to an exchange-traded fund is a noteworthy development. As experts at Binary Tree Analytics, we study and analyze various financial structures, and FDEU serves as a perfect case study in this area.
Investors must comprehend the advantages and disadvantages of each structure and carefully consider which one aligns better with their investment goals. Unlike ETFs, CEFs are independent entities that issue shares only once, leading to potential premiums or discounts. ETFs, on the other hand, create units continuously, which usually eliminates the occurrence of premiums or discounts due to their arbitrage mechanisms.
This difference in structure can result in CEFs trading at significant premiums or discounts. For example, the Gabelli Utility Trust (GUT), a defensive utilities CEF, trades at a substantial premium of 124% to its net asset value (NAV). Conversely, there are CEFs like BlackRock ESG Capital Allocation (ECAT) currently trading at a significant discount of -12%. Such disparities arise due to market conditions and investor sentiment.
FDEU has historically traded at discounts to NAV, with an average of more than -8% over the past four years:
Notably, FDEU has a contingent conversion feature in its fund documents. In March 2023, the fund management triggered this feature, and as a result, the conversion from CEF to ETF was approved by the board of trustees:
WHEATON, Ill.–(BUSINESS WIRE)–First Trust Advisors L.P. (“FTA”) announced today that the Board of Trustees of First Trust Dynamic Europe Equity Income Fund, a closed-end fund managed by FTA, approved the reorganization of FDEU into a to be-created exchange-traded fund (“ETF”), that will be traded on the NYSE Arca and will be an actively managed ETF managed by FTA and sub-advised by Janus Henderson Investors, FDEU’s current sub-advisor.
Under the terms of the proposed transaction, which is expected to be tax‑free, the assets of FDEU would be transferred to, and the liabilities of FDEU would be assumed by, the new ETF, and shareholders of FDEU would receive shares of the new ETF with a value equal to the aggregate net asset value of the FDEU shares held by them. It is currently expected that the transaction will be consummated during 2023, subject to requisite shareholder approval of FDEU and satisfaction of applicable regulatory requirements and approvals and customary closing conditions.
Several key points deserve attention:
- Firstly, the old CEF company will be dissolved, and its assets and liabilities will be transferred to the new ETF.
- The conversion will take place at the net asset value.
- Shareholders’ approval is essential for the conversion to proceed (the CEF board of trustees has already approved the conversion).
Implications of the Conversion
1. Elimination of NAV Discount
The market has already priced in the successful conversion, narrowing the discount to NAV significantly after the board of trustees’ vote:
Prior to the vote, FDEU traded at a discount of approximately -12% to NAV, which has now significantly narrowed to only -3.6%.
2. Leverage Ratio Adjustment
FDEU currently has a 24% leverage ratio, which will need to be reduced to 0% as ETFs cannot have outright leverage. This will require the selling of assets and repayment of debt:
The leverage in FDEU is obtained through TRS facilities with providers, and these facilities will be terminated.
The timing of the unwinding process is critical as it entails selling assets. If the market experiences an extended risk-off period during this transition, the fund may incur permanent capital losses from such sales. Therefore, there is a level of risk associated with market conditions when removing leverage.
3. Adjustment of Management Fee
CEF fees are often higher compared to ETFs, and in the case of FDEU, the non-leverage fees amount to 1.28% of managed assets:
ETFs generally charge lower fees, with the Vanguard European Stock Index Fund ETF (VGK) being a major competitor, charging only 0.11%. When FDEU converts, it will need to adjust its fees to remain competitive. It is commendable that the board of trustees is considering the best interests of shareholders by narrowing the discount to NAV. However, with FDEU’s historical underperformance compared to VGK, the portfolio management team cannot justify charging fees that are significantly higher than VGK’s.
4. Reduction of Dividend Yield
Currently, the CEF offers a dividend yield of 6.4% due to its use of leverage and CEF structure. CEFs can support high dividends through return of capital, even if the underlying holdings do not perform well. However, ETFs do not have this flexibility due to their structure.
Once the conversion is complete, the fund will only be able to distribute what it generates, resulting in a dividend yield of approximately 3.4%. This represents a considerable reduction compared to the current yield.
Existing FDEU shareholders face two primary risk factors:
- Structural risk factors associated with the CEF-to-ETF conversion.
- Market-related risk factors concerning the performance of underlying European equities.
At present, the potential downsides outweigh the upsides in terms of structural factors. The only foreseeable benefit is the elimination of the -3% discount to NAV; however, the fund is unlikely to trade at a premium. On the other hand, if the conversion encounters any issues, reverting back to a CEF, the discount may return to a level of -10% (although the probability of this happening is low).
If there are delays in implementing a new fee structure, shareholders will be left with a vehicle charging excessive fees compared to a straightforward option like VGK.
Regarding equities risk factors, 2023 has been relatively benign despite various lingering risks. Without factoring in the narrowing of the discount, FDEU has experienced a total return of approximately +10% this year. However, with a potentially challenging September ahead, it is prudent for investors to adopt a conservative approach.
Conclusion
FDEU is a European equities CEF that has been approved for conversion into an ETF, pending shareholder approval. The current company will be dissolved, and the assets and liabilities will be transferred to the new ETF at NAV. The conversion involves significant adjustments, such as the elimination of the leverage ratio, amendment of the management fee, and a reduction in dividend yield.
Considering the structural risks associated with the conversion and the performance of European equities, current FDEU shareholders face more potential downsides than upsides. Therefore, we recommend selling and waiting for the conversion process to conclude. Institutional investors seeking exposure to European equities during this interim period may consider VGK as an alternative.
