As beginning investors grow their knowledge, most become well-versed in mutual funds and exchange-traded funds (ETFs). Both serve as a means for smaller investors to invest in a professionally managed fund that pools the money of a number of investors to track an investment style, a market sector, a specific asset class or a number of other objectives.
However, investing novices may be less knowledgeable about closed-end funds. Closed-end funds (CEFs) offer some of the attributes of open-end mutual funds and ETFs as well as some unique qualities of their own for investors. Read on to learn how closed-end funds work and what type of investor might benefit from them.
Closed-end funds, mutual funds and ETFs compared
Investing in an open-end mutual fund entails buying or selling shares during the trading day, but the transaction isn’t completed and the price isn’t set until after the stock market closes. Unless the fund is closed to new investors, new shares are created anytime an investor buys into the fund.
ETFs, however, can be purchased throughout the trading day when the stock market is open. Shares are bought or sold like stocks and the transaction is completed as soon as the trade is executed. ETFs are valued throughout the trading day while the market is open and the price constantly changes to reflect that.
In many ways, closed-end funds are a hybrid of open-end mutual funds and ETFs. Like mutual funds, closed-end funds are pooled investment funds and are organized under the Investment Company Act of 1940. Like ETFs, shares of CEFs are bought and sold like stocks during the trading day. And like both mutual funds and ETFs, CEFs have expense ratios. This covers the costs of running the fund and provides a level of profit margin for the fund company.
Though there are many similarities between mutual funds and ETFs, CEFs differ in a few significant ways.
One key difference is that closed-end funds are created via an initial public offering (IPO). Once the funding is complete, there are no additional shares of the fund created. The CEF managers take the proceeds of the IPO to purchase the securities that will make up the fund’s portfolio.
Premiums and discounts
Another key difference in CEFs is the prevalence of discounts and premiums. The closed structure of CEFs lends itself to funds often trading at a level that is higher than the fund’s net asset value (known as a premium), or a level that is lower than the fund’s net asset value (known as a discount).
It may be helpful to think of premiums and discounts like this:
- A CEF with a premium of 10% means that the price at which the CEF is trading is 10% higher than the value of the fund’s underlying holdings. In more simplistic terms, a premium of 10% is like paying $1.10 for $1.00 worth of assets.
- A CEF selling at a discount of 10% would conversely be like paying $0.90 for $1.00’s worth of assets.
Premiums and discounts by themselves are not always significant. If a CEF consistently trades at a level that equates to a 10% premium, the premium isn’t that important. At the end of the day, it is the market price of the CEF that determines whether or not an investor has a gain or a loss when they ultimately sell their shares.
What is perhaps a more important factor when looking at CEF premiums and discounts is to look at the fund’s trend in this area over time.
The use of leverage
Because CEFs don’t issue new shares, one of the ways the fund can raise additional capital is via the use of leverage, specifically by borrowing money that must be repaid or by issuing preferred shares of the CEF.
Just as a company may use financial leverage on their balance sheet, leverage can work to the CEF shareholder’s advantage to magnify gains in the fund’s portfolio of underlying securities. On the other side of this coin, investment losses will be magnified as well.
Another aspect of leverage is that the fund will need to make interest payments on any debt incurred or dividend payments on the preferred shares issued. Both of these activities can impair the CEF’s underlying capital, which can limit the money available to pay dividends or interest to shareholders. In other words, the use of leverage can restrict the shareholders’ overall return from the CEF.
Dividends or return of capital
Like open-end mutual funds and ETFs, closed-end funds generally make distributions to shareholders. With mutual funds and ETFs, the distributions usually take one of two forms:
- Capital gains distributions generated by the sale of the fund’s securities. The gains can be either short- or long-term in nature.
- Dividends and interest gain generated from the activity of the fund’s portfolio.
Closed-end funds generate these types of distributions as well, depending upon the type of securities the CEF invests in and the activity in the portfolio. But CEFs have an additional potential form of distribution that open-end funds and ETFs don’t offer: the return of the fund’s capital to shareholders.
This aspect of CEF distributions can be quite complicated. On the one hand, investors are getting their own money back in a sense. On the other hand, CEF managers might use this strategy to manage the fund’s premium or discount levels. Managers might also return a fund’s capital to avoid selling holdings that they feel should be retained in the fund.
As a shareholder or potential shareholder, it’s critical that you understand the fund’s distribution policies. If a fund commits to a distribution policy but its earnings are not sufficient to support this policy, the fund may be forced to distribute its assets back to shareholders, eroding the capital of the fund. Over time this could result in lower returns or even the liquidation of the fund.
Considerations for closed-end fund investors
Closed-end funds can offer a way to invest in assets that might be less liquid than, say, blue-chip stocks. One of the biggest advantages that a CEF offers is the fact that the fund managers don’t need to maintain a cash balance to cover shareholder redemptions, as is the case with open-end mutual funds. This aspect makes CEFs a good structure for investing in relatively illiquid securities like certain forms of debt securities or alternative assets.
However, the liquidity of CEFs is largely determined by the market. While CEFs are traded on public stock exchanges like stocks, for every seller of shares there needs to be a willing buyer on the other side of the transaction. If your CEF shares are not in high demand, you might be forced to hold on to your investment or accept a price that is below your expectations.
As an investor, there are many considerations to weigh before you decide whether or not CEFs are right for your portfolio. At the very least, you should research potential CEFs’ underlying investments, the current and historical premiums and discounts, as well as the funds’ distribution policies before making a decision.