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What You Need to Know About Closed-End Funds

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here

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Investing

Stocks vs. Options: Discover Which May Work Best For You

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Most investors are familiar with stocks and the stock market. Popular stock benchmarks like the Dow Jones Industrial Average and S&P 500 are widely quoted in the news. The health of the stock market is often equated with the health of the economy.

Stock options are another way to participate in the movement of stocks, and they can offer investors an alternative to direct ownership of stocks. We will look at both stocks and options and discuss how investors might use these tools.

Stocks explained

We hear the term “stock market” on a regular basis. But what does owning shares of a company’s stock actually entail?

Owning shares of stock in a company actually makes the shareholder an owner. This doesn’t mean you can walk into to the company’s headquarters and take over, but it signifies that you have a claim on the company’s earnings.

There are two classes of stock: common and preferred. Not all companies issue preferred shares. Common shares are the shares whose prices generally are quoted in reference to the stock of companies like Apple, Exxon Mobil and others.

Common shareholders have the right to vote at the company’s annual meeting (either by mail, online or in person in some cases) and to receive any dividends paid by the company to common shareholders.

With preferred stock, shareholders have a preference on any dividends declared by the company — meaning these shareholders would receive their payments before common shareholders in the event there would be a problem making dividend payments. Preferred stock does not carry voting rights, however.

How stocks are traded

Stocks are traded during the period when the stock markets are open — for example, from 9:30 a.m. to 4 p.m ET at the New York Stock Exchange. Shares can be bought or sold online using a brokerage account. For those working with a broker, orders can be placed with the broker, whose firm will execute the trade on your behalf.

When trading stock, you generally will incur a transaction cost of some sort. Full-service brokerage commissions generally are among the highest. Examples of full-service brokers include Merrill Lynch and Morgan Stanley. Online transaction costs generally are cheaper, with some firms offering a number of commission-free trades to induce new clients to move their business to the firm.

You will need to have an account with a custodian in order to trade stocks. There are many options available to you, ranging from traditional full-service brokerage firms to discount brokers like Charles Schwab, Fidelity and TD Ameritrade.

Pros and cons of stock investing

Some pros of stock investing include the following:

  • Investing in stocks can be a means of accumulating wealth. As the underlying company grows over time, the price of its stock has the potential grow along with its business.
  • Stocks can serve as a hedge against inflation.
  • Shareholders can benefit from preferential tax rates on long-term capital gains if they hold their shares for at least a year.
  • Stocks are traded throughout the day, and transactions generally are implemented almost instantaneously, especially on shares of widely traded stocks.
  • There are a variety of order types that can be used to set limits on the downward movement of your shares or to buy when a price trigger is met.

Here are some cons of stock investing:

  • Investing in stocks takes a level of research and knowledge that entails understanding the company’s underlying business and the factors that might influence the stock’s performance. This can take time and effort. Whether you are buying the shares to hold for a period of time or you plan to day trade, it’s important that you understand what you are doing.
  • Owning individual stocks can make it difficult to diversify your investment portfolio, especially for small investors. This might entail holding a concentrated position in just a few shares; if one or more of the stocks hits a rough patch, it can have an outsize impact on your wealth.

Options explained

Stock options offer the option holder the right to buy or sell shares of the underlying stock at a set price within a certain time frame. Beyond options that are traded on exchanges, employee stock options are issued by some companies as a form of compensation to their employees (or vendors and contractors in some cases).

Options can become quite valuable depending on whether the underlying stock moves in the direction the investor expects — up or down — as long as the move happens before the option expires.

Key option terms

A call option allows the option holder to purchase the stock at a set price within a set time.

A put option allows the buyer to sell shares of the stock at a set price within a set period of time.

The strike price is the price at which the option can be exercised.

The premium is the amount the buyer of the option pays for the option, and it represents the maximum profit the seller of the option can realize.

The option seller will be obligated to sell shares to the option holder if the call option is exercised or buy them in the case of the exercise of a put option. They can face a significant risk of loss.

For example, if a call option for 100 shares of a stock is exercised at the strike price of $10 per share, the option seller needs to furnish those 100 shares to the option holder. If they own the shares (a covered call), they would transfer the shares to the option buyer. If they don’t own the shares, they will need to go into the market, buy the 100 shares at the market price and furnish them to the option holder.

How options are traded

Options are traded on exchanges like the Chicago Board Options Exchange (CBOE). Options trade as contracts, with one contract covering 100 shares of the underlying stock or other security (exchange-traded funds, etc.).

The price you would pay for an option (or would receive if selling one) — the premium — has two components. The intrinsic value is the difference between the strike price and the market value of the underlying stock. The time component has to do with other factors, including the time until the option expires and the volatility of the stock. The price of the option contract will fluctuate based on these factors.

Three common options trading strategies

The long call is an options strategy in which the investor buys a call option with a strike price below their expectations for the stock’s price. They then can exercise the option and buy the stock at a below-market price if they are correct (and the option hasn’t expired).

In a covered call, the investor sells a call option at a strike price above the current price of the stock they own. If the stock remains below the strike price, they keep both their shares and the premium they earned when selling the option. If the stock surpasses the strike price, the investor will lose their shares but keep the option premium.

The long put is a bet on the decline of the price of the stock. The investor buys a put option. If the stock price falls to a level below the strike price, the investor may sell shares at the strike price. For example, if the strike price is $50 per share and the stock falls to $30 per share, the investor makes $20 per share, less the cost of the option. If the stock price is above the strike price, then the option will expire worthless and the investor is out the cost of the options.

Pros and cons of options trading

Here are some pros of options trading:

  • Options trading generally requires less of an investment than buying the shares of the underlying stock outright.
  • For option buyers, the maximum downside risk is the amount paid for the option. If it expires worthless, that is the extent of your loss.
  • Buying and selling options can provide relatively large gains for a relatively small investment.

Some cons of options trading include the following:

  • Like any other trading endeavor, successful option traders take the time to master what they are doing. That means it might not be the right path for “dabblers.”
  • Option sellers can lose a great deal of money if the stock moves drastically away from the strike price. You have virtually unlimited liability to provide shares for a call option buyer or to buy shares from a put option buyer.
  • Options come with a time limit. If the stock doesn’t move in a direction that benefits the option trader, the option can expire worthless.

How stocks and options are similar (and different)

Trading options has some similarities to trading stocks, including:

  • Success in both endeavors will be related to accurately picking the right stocks to focus on and the direction the stocks will move.
  • Choosing the right stocks and their underlying options to trade takes research and an understanding of the markets.

There are differences to be aware of, however:

  • Investing in stocks can be a long- or short-term endeavor. Options, by their nature, have a short-term focus.
  • Options are a “bet” on the movement of a stock and are short-term by nature.

While there are no hard-and-fast profiles of a typical stock or option investor, here are some common traits:

  • Stock investors typically will look at the fundamentals of the company as well as the relative price of the shares compared to their historical levels. Stock investors are interested in the price of the shares as well as the performance of the company. Stock investors may be short-term traders or long-term investors.
  • Options require less money than the shares of the underlying stock. Options traders often are those who want to profit from the price movement of a particular stock without having to own the stock itself.
  • It is common for investors to utilize both stocks and options. As an example, an investor who owns a stock might write options as way to make some additional money from the stock. Or they might purchase a put option to hedge against a drop in the stock’s price. There are many strategies investors can use that combine owning stocks and trading options to enhance their overall investing returns.

Bottom line

Investing in stocks and trading options are not mutually exclusive. In fact, options can be used as a method to complement your stock trading activities. Call options can be a way to speculate on the price of particular stock without having to commit the capital to buy the shares. Conversely, put options can be a good way to hedge against a drop in the price of a stock in which you currently hold shares.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here

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Investing

What to Consider Before You Exercise Employee Stock Options

Editorial Note: The content of this article is based on the author’s opinions and recommendations alone. It has not been previewed, commissioned or otherwise endorsed by any of our network partners.

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Congratulations if you were recently granted stock options by your employer that are tied to the company’s stock. Options can be a lucrative part of your compensation, and you should look to take advantage of this financial opportunity.

Stock options are issued to employees of companies whose stock is publicly traded as well as to employees of companies that have not yet gone public. In the latter case, it’s a way for key employees to participate in any potential upside in the firm’s stock when the company does go public.

Some private companies also may provide stock as compensation to outside consultants and advisors as a way to reduce their cash outlay for these services and to potentially pique their interest in working with the company.

Here are some things you should know if you are granted employee stock options (ESOs) and how to determine whether it makes sense to exercise them.

How employee stock options work

Employee stock options are granted to specific employees by their companies. These stock options grant employees the right to purchase a number of shares at a fixed price for a specified period of time.

Companies may grant options to enhance the compensation of certain employees and also to provide an incentive for outstanding performance. “If the company does well, then the stock will do well too” might be the thought process of an employee holding options. It ties the financial well-being of these employees at least in part to the financial fortunes of the company.

Here are some key terms to know about ESOs:

  • Grant date: The date on which your employer granted you the options. This date is important in that any taxes due later on in the process could be tied to this date.
  • Vesting schedule: The schedule under which you eventually become vested in the options. Vesting means that you take full control of the options. The vesting schedule commences with the date the options are granted to you. The schedule will lay out the timetable over which you become eligible to exercise the options, converting the options to shares of the company’s stock. Vesting for the options may occur all at once or over a defined period of time. For example, the options might vest at a rate of 20% per year over a five-year time frame.
  • Strike price: Also known as the exercise price or grant price. This is the specified price at which you can purchase the shares by exercising the options. This price generally will be at a higher level than the stock’s price on the grant date. Note, however, that the actual price on the date you are eligible to exercise some or all of the options might be higher or lower than the strike price based on the performance of the stock over time.
  • Expiration date: The date by which your options must be exercised; otherwise, they will expire. If the options vest over time, there likely is an expiration date for each lot as they vest. If you allow the options to expire without exercising them, they become worthless.

Types of employee stock options

There are two types of employee stock options: nonqualified stock options and incentive stock options (ISOs). They differ in several ways and should play a role in the exercise strategy you choose.

“The first thing you may want to do is identify whether you have been granted nonqualified stock options or incentive stock options, as the tax implications of an exercise are materially different,” said Daniel Zajac, certified financial planner at Simone Zajac Wealth Management Group, which is based outside Philadelphia. A good portion of Zajac’s practice is devoted to advising clients on stock option-related issues.

Nonqualified stock options

Nonqualified stock options are the simpler of the two types in terms of taxation. “When you exercise nonqualified stock options, any gain will likely be taxed in the year of exercise as ordinary income, subject to payroll tax,” Zajac said.

When you exercise the option, you pay taxes on the difference between the share price at which you exercise the options and the grant price. This gain is taxed as ordinary income, just like your salary and most other types of income you might earn. Besides federal and state income taxes, the income generated by the exercise of the options would be subject to payroll taxes, such as FICA (Social Security) and Medicare, just like any other income earned from employment.

Note that once you exercise the options, if you hold the shares of stock for at least a year, any gain on the sale of those shares would be taxed at lower capital gains rates.

Incentive stock options

ISOs are more challenging from a tax perspective. “The exercise of incentive stock options is materially more complicated, as tax will depend upon how long you’ve owned the option, when you exercised the option and when you sell your shares,” said Zajac. “You may also need to plan for both ordinary income tax, long-term capital gains tax and the alternative minimum tax.”

Unlike with nonqualified options, there are no payroll taxes at the time of exercise, but the exercise of the ISO potentially would count as income for alternative minimum tax purposes.

“The alternative minimum tax, or AMT, is calculated every year along with your regular tax. As a taxpayer, you pay the higher of the two,” Zajac said. “In a calendar year that you exercise and hold incentive stock options, it’s possible that your AMT will be the higher of the two, and you should plan for this potentially large tax bill.”

The good news for many readers is that the tax reform legislation enacted at the end of 2017 raised the income threshold to trigger the AMT, meaning that fewer middle-income taxpayers will be subject to this extra tax.

Under certain circumstances, the sale of the shares after exercise of the options can be subject to the generally preferential capital gains tax rate for federal taxes. If the ISOs are held for at least a year prior to exercise and then the shares are held for at least a year after exercise, any gain on the sale of those shares would be subject to long-term capital gains rates.

The following example illustrates the advantage of paying tax at long-term capital gains rates: For 2019, someone who files their taxes as single hits the marginal 22% tax bracket for ordinary income at an income level of $39,476 and reaches the 24% marginal bracket at an income level of $84,201.

By contrast, the long-term capital gains rates for those filing as single in 2019 are:

  • 0% up to an income level of $39,375
  • 15% from $39,376 to $434,550 in income
  • 20% above $434,551

The differences in rates are similar for taxpayers who are married filing jointly.

Deciding whether to exercise the options

The stock’s market price: The most key consideration when deciding whether to exercise your options probably is where the current market price of the underlying stock is relative to the strike price on the options.

If the strike price of the options is $20 per share, for example, but the current market price of the stock is at $15 per share, you’d be foolish to exercise the options. If you wanted to purchase the stock, it would be more economical to buy it outright using a brokerage account or another method.

If the market price is below the strike price, it likely makes sense to hold the options until such time as the stock rises above the strike price. If the options expire worthless, that is still a better outcome than overpaying for shares of the stock.

Taxes: With most investment and financial decisions, taxes should be a consideration but not the driving force. If the market price of the stock is higher than the exercise price, you can set aside some of your proceeds to cover the taxes.

Additionally, you may need the proceeds from the shares to beef up cash reserves, pay off debt, cover an unexpected major expense, etc. These are all valid reasons to exercise options, but you will want to be sure that exercising the options is the best way to raise this cash prior to exercising.

Some strategies to consider

When exercising employee stock options, you can always pay cash to purchase the shares.

Beyond this, there are a few common strategies you can consider:

  • A cashless exercise occurs when vested options are exercised and the shares are sold immediately. Any excess cash from the transaction would be deposited in your account.
  • A cashless hold means you exercise a sufficient number of options to sell some of the shares. The cash from the sale will cover the cost of the remaining shares.
  • Let the options expire If the strike price is higher than the current market price of the shares, it makes no economic sense to exercise the options.

Bottom line

Employee stock options can be a lucrative form of compensation, especially if the company’s shares appreciate nicely over time. Understanding the ins and outs of managing and exercising these options can help enhance their value.

Advertiser Disclosure: The products that appear on this site may be from companies from which MagnifyMoney receives compensation. This compensation may impact how and where products appear on this site (including, for example, the order in which they appear). MagnifyMoney does not include all financial institutions or all products offered available in the marketplace.

Roger Wohlner
Roger Wohlner |

Roger Wohlner is a writer at MagnifyMoney. You can email Roger here