Mexico Fund Inc. (NYSE: MXF) is receiving some criticism from shareholders with regards to its chronic discount to net asset value. City of London, which owns 17% of the fund, disclosed yet another letter to the board in a Schedule 13D filing with the SEC. In the letter, the hedge fund argued that the board must take immediate measures to reduce the excess supply in shares and narrow the discount.

Unlike mutual funds, closed-end funds like Mexico Fund do not automatically trade at the value of their underlying assets. Rather, shares of the fund are purchased and sold much like a regular stock. As a result, it is common for some closed-end funds to trade at a premium or discount to their net asset value, depending on investor sentiment about the future of the fund.

Unfortunately, the economic crisis has led to many investors pulling their money out of funds like the Mexico Fund. The result has been a chronic discount to net asset value that recently reached in excess of 25%. It is not uncommon for large investors to turn activist and push for changes to narrow the discount. The recommendations often range from tender offers to liquidations, designed to unlock value.

Instead of taking these actions, the Mexico Fund instead opted to issue new shares in a rights offering! Unfortunately, there was not enough liquidity in the stock’s market and shares dropped even lower as a result of the excess supply. Meanwhile, the company has lowered its quarterly cash dividends and reduced its share repurchasing plans in moves that also damaged shareholder value.

Mexico Fund issued 5,021,908 shares through their rights offering at a significant discount to net asset value, while it was only authorized to repurchase 2,956,814 shares through its in-kind share repurchase program. Things are made even worse by a dividend reinvestment program that also continues to issue shares and contribute to the fund’s oversized nature.

City of London finished their letter with a threat:

"City of London continues to hold the belief that the Board needs to immediately address the problem of excess supply in order to significantly and permanently reduce the discount at which the Fund's shares trade to net asset value back much closer to parity. If the Board's objective in proposing to eliminate the in-kind repurchase is to more effectively reduce the Fund's trading discount, then City of London suggests the Board inform shareholders openly and publicly of their intentions. While we have no present plans or proposals on the issue, we may look to act in the future if the Board does not demonstrate the necessary commitment to managing this Fund."

In the end, if City of London is successful, Mexico Fund may be a stock worth watching for investors when it returns to net asset value.