Closed-End Funds: Worth Your Investment?

Closed-end funds are a type of mutual fund that issues a fixed number of shares through an initial public offering (IPO) to raise capital for its initial investments. They are actively managed by investment firms and invest in a basket of securities. Unlike open-end funds, closed-end funds do not issue new shares or buy back shares from investors, and trade on a stock exchange throughout the trading day like stocks or exchange-traded funds (ETFs). One of the key features of closed-end funds is their ability to use leverage, which can lead to greater risk but also greater rewards. They are also able to invest in less liquid and more volatile securities, such as emerging-markets stocks and municipal bonds. While closed-end funds offer the potential for higher returns, they are generally considered a more complex and risky investment vehicle than open-end funds due to their use of leverage and the fact that they trade at a discount or premium to their net asset value.

Closed-end funds vs open-end funds

Closed-end funds and open-end funds are both professionally managed funds that pool investors' resources to invest on a larger scale. However, they differ in several key ways.

Shares

Closed-end funds have a fixed number of shares offered through an initial public offering (IPO). No new shares are created, and no new money flows into the fund. To gain access to a closed-end fund, investors must find someone willing to sell shares or wait for some to become available on the market.

On the other hand, open-end funds do not have a limit on the number of shares issued. They create new shares when someone buys and remove shares from circulation when someone sells.

Trading

Closed-end funds trade like stocks on a stock exchange throughout the day, and their prices fluctuate according to supply and demand. They can trade at a premium or discount to their net asset value (NAV).

Open-end funds, on the other hand, trade only at the end of each day at their NAV. The price is based on the fund's assets minus its liabilities and is the only price at which shares can be bought or sold that day.

Popularity

Open-end funds are significantly more common than closed-end funds. According to the Investment Company Institute, closed-end funds had $252 billion in assets at the end of 2022, compared to trillions for open-end funds.

Buying and Selling

Closed-end funds are bought and sold on the open market through a brokerage account. Open-end funds can usually be purchased directly from the fund's sponsoring company.

Management

Closed-end funds are actively managed and tend to focus on a single industry, sector, or region. They also frequently use leverage to boost returns but increase risk.

Open-end funds, on the other hand, are often index funds that track a market index.

Dividends

Closed-end funds tend to pay out higher dividends than open-end funds, partly because of their use of leverage.

Closed-end funds' use of leverage

A distinguishing feature of closed-end funds is their ability to use leverage to boost their returns to investors. This is done by borrowing money to fund asset purchases, which can increase returns. This strategy is risky, as it can magnify losses when stocks are falling.

Closed-end funds are allowed by law to use leverage. According to the Investment Company Act of 1940, CEFs can issue debt in an amount up to 50% of net assets and preferred shares in an amount up to 100% of net assets. In practice, the average leveraged CEF has a leverage ratio of 33%.

Leverage can be used in the form of preferred stock, reverse purchase agreements, dollar rolls, commercial paper, bank loans, and notes, among other methods.

The use of leverage has its benefits and drawbacks. Leverage can lead to higher distribution rates and greater returns, especially in a low-interest-rate environment. However, it can also result in more volatile share prices and higher costs, including interest payments.

When deciding whether to invest in closed-end funds, it is important to consider the level of leverage used, as it can impact the risk and potential returns of the investment.

Buying closed-end funds at a discount

One of the appealing attributes of closed-end funds (CEFs) is the potential to buy shares at a discount to their net asset value (NAV). CEFs frequently trade at discounts, and in volatile markets, these discounts can widen significantly, offering investors the opportunity to purchase shares well below their NAV.

A CEF's market price is largely determined by demand and supply. Demand for a CEF is affected by market dynamics, investor sentiment, and quantitative and qualitative factors about the fund. The difference between the market price, which typically fluctuates throughout the trading day, and the NAV is expressed as a premium or discount percentage relative to NAV. For example, a fund trading at a price of $18 per share with a $20 NAV is said to be trading at a 10% discount.

When evaluating CEFs, investors may benefit from focusing on fund distributions and the primary role distributions have played in longer-term total returns. Distributions, not discounts, have historically been the primary contributor to total returns over longer periods.

While CEF distributions are expected to positively contribute to returns, over longer periods, distributions become an increasingly larger positive component of total return, while the change in discounts contributes less and less. Therefore, investors may be better served by focusing on a fund's distribution and NAV performance.

• How much is the fund paying?
• What is the distribution composed of, and how does the distribution rate compare to the fund's NAV performance over relevant time periods?
• Is the NAV return sufficiently high to pay the current distribution?
• Does the performance seem reasonably sustainable over your time horizon?

It is important to note that buying CEFs at a discount can be a risky strategy if it is based on the assumption that the fund's discount will narrow over time. Additionally, it is crucial to consider the fund's investment philosophy, strategy, portfolio characteristics, amount and cost of leverage, expense ratio, bid-ask spread, and exposures to risk factors when making investment decisions.

Closed-end funds' pricing and trading

Closed-End Funds Pricing and Trading

Closed-end funds are priced and traded differently from open-end funds. Open-end funds are priced once per day at the end of the trading day, and the price is based on the net asset value (NAV) of the fund. In contrast, closed-end funds trade on a stock exchange, and their prices fluctuate throughout the trading day based on supply and demand. This means that closed-end funds can trade at a premium or a discount to their NAV.

When a closed-end fund trades at a premium, it means that the trading price is higher than the NAV, and investors are paying more than the underlying assets are worth. On the other hand, when a closed-end fund trades at a discount, it means that the trading price is lower than the NAV, and investors have the opportunity to purchase the fund's shares at a price lower than the value of its underlying assets.

The pricing of closed-end funds is influenced by various factors, such as the fund's performance, the popularity of the sector it invests in, and the reputation of its manager. Investor perception, broker recommendations, and the use of leverage can also impact the demand for closed-end fund shares and, consequently, their market price.

Unlike open-end funds, closed-end funds do not repurchase their shares from investors, and they do not maintain a large cash reserve. This gives closed-end funds more money to invest and the ability to use leverage to boost their returns. However, the use of leverage can amplify losses during market downturns, increasing the volatility of closed-end funds compared to their open-ended counterparts.

Another unique characteristic of closed-end funds is that they only issue a fixed number of shares during their initial public offering (IPO). No new shares are created, and no new capital flows into the fund after the IPO. As a result, investors seeking to gain access to a closed-end fund must find someone willing to sell shares or wait for existing shares to become available on the market.

Closed-end funds' pros and cons

Closed-end funds are a type of mutual fund that issues a fixed number of shares through an initial public offering (IPO). They are actively managed and tend to focus on a single industry, sector, or region. They can be purchased and sold on a stock exchange, but no new shares will be created, and no new money will flow into the fund.

Pros

• Steady stream of income: Closed-end funds often provide a steady stream of income, usually on a monthly or quarterly basis, which is more frequent than the biannual payments provided by individual bonds.
• Potential for higher returns: Closed-end funds may be able to offer higher overall returns than open-end funds due to their ability to use leverage and the fact that they don't have to maintain a large cash reserve.
• Opportunity to buy at a discount: Closed-end funds can trade at a discount to their net asset value (NAV), providing an opportunity for investors to buy at a lower price than the value of the underlying assets.
• Actively managed: Closed-end funds are actively managed, allowing investors to benefit from the fund managers' skills and expertise.
• Wider range of investment options: Closed-end funds can invest in illiquid and less-accessible assets, providing a wider range of investment options.

Cons

• Higher risk: The use of leverage in closed-end funds can lead to greater risk, especially during market downturns.
• Less liquid: Closed-end funds tend to be less liquid and more volatile than open-end funds, making it more difficult to buy or sell shares.
• Higher fees: Closed-end funds often have higher management fees and brokerage fees than other types of funds.
• Limited market liquidity: Closed-end funds may have limited market liquidity, which can present a price risk for investors looking to buy or sell a large number of shares.
• Premium price: For buyers, the market price of a closed-end fund may be higher than the true fair value (NAV) of the shares.

Frequently asked questions