Color This Deal In Crimson And Green

Mutual funds are designed to be the small investor's friend. By pooling their money and hiring a professional manager, the small fry can compete with the giant sharks that dominate the investment world. Or so the thinking goes. But sometimes, the big guy gets a much better deal out of a mutual-fund investment than the small guy can dream of getting. A case in point: the way a money manager for Harvard extracted a far better deal for the Crimson from the Korea Fund than mom-and-pop shareholders got. It's all perfectly legal.

You've probably never heard of the Korea Fund, which is what investment types call a closed-end fund. Closed-ends are different from regular mutual funds, known as open-end funds. You buy or sell shares of an open-end fund by dealing with the fund directly. Closed-end funds, by contrast, trade like stocks. A fund manager raises cash with a one-time offering to investors, then puts the money to work. For a variety of reasons, including the fact that you have to pay commissions to buy and sell closed-end shares, they typically trade below their net asset value per share. (That's the value of the securities a fund owns, divided by the number of shares.) Open-end funds trade at net asset value.

Enter Sowood Capital Management, a Boston-based hedge fund founded last year by folks who used to work for the Harvard Endowment. When they set up shop on their own, they continued working for Harvard, which gave them money (I don't know how much) to manage. Sowood manages money for other clients, too, but its Korea Fund play is strictly Harvard.

Sowood was drawn to the Korea Fund because it was so cheap relative to the value of its assets. For part of last year, Korea Fund shares, which trade on the New York Stock Exchange, were selling for as much as 20 percent less than the value of the fund's stocks. Using a time-honored big-fish maneuver, Sowood bought 22 percent of the fund's shares for Harvard and began agitating for the fund to break itself up. That would let shareholders get net asset value for their stock.

Sowood talked about finding new managers to replace Deutsche Asset Management at the fund's helm, and in general made a pest of itself. To make peace, the Korea Fund agreed to buy back shares at 98 percent of net asset value. That's so close to NAV that even for a $300 million holding like Sowood's, the difference wasn't worth quibbling over. But rather than buying back its shares for cash, the Korea Fund did a stock swap. Holders turned in Korea Fund shares and in return got pieces of the 75 Korean stocks that the fund owned. To own South Korean stocks, you've got to register with the South Korean government. You've also got to know what to do with obscure (to U.S. investors) holdings like NEPES Corp. It's no surprise, then, that most Korea Fund holders didn't accept the offer. But Harvard did. By my math, Harvard is at least $15 million ahead of where it would be if it were a regular old Korea Fund shareholder. (Harvard, Sowood and the fund all declined to comment.)

To be sure, retail holders did benefit from Sowood's raid on the fund. The stock price rose, relative to asset value, so holders could get a better price if they chose to sell. The fund committed to future buybacks (payable in Korean stocks rather than cash) that will presumably help support the fund's stock price. But Harvard benefited more--it got 98 percent of asset value for stock that traded recently at 93 percent. "Retail shareholders are better off than they would have otherwise been, but they're not getting the full benefit," says Thomas Herzfeld, whose Miami-based Thomas J. Herzfeld Advisors is a leading analyst and dealer in closed-end funds.

The idea here isn't to point a finger at Harvard or Sowood. It's to show that size matters. Any player with lots of money, staying power and a thick hide could have gotten the same advantages that Sowood got for Harvard. (Indeed, the Korea Fund came under attack from a British money-management firm last week--but that's a tale for another day.)

The moral: in the fund game, as in basketball, you can pretty much bet that the big guy can take the little guy to the cleaners almost every time.