While closed-end funds (CEFs) have existed since the late 19th century, they only represent a small percentage of the managed funds available to investors today. In fact, only 461 CEFs currently exist in the United States, compared with approximately 7,500 open-end mutual funds and more than 3,000 exchange-traded funds- making CEFs less than 5% of the total.1
Closed-end funds share certain characteristics with mutual funds and exchange traded funds: all three are professionally managed, offer investors diversified portfolios of securities, and are regulated by the Securities and Exchange Commission. CEFs, however, have certain distinguishing features that set them apart. The following will explain these features, as well as highlight the opportunities and risks associated with them. Here are some CEF basics.
How Closed-End Funds Are Created and Traded
Closed-end funds are created by professional investment managers. After deciding on the asset type and objective (see below for more detail), an investment manager will raise money through an Initial Public Offering (IPO) arranged by investment banks. The proceeds of the underwriting are used to buy securities that are assembled into a pool constituting the assets of the fund. The investment manager then lists the fund on an exchange, allowing investors in the initial public offering to sell their shares to other investors. From the time of the listing, the fixed number of shares in a closed-end fund trade in the secondary market just as any other listed stock, which means investors may buy or sell them throughout the trading day.
In general, the price of a closed-end fund, as determined by buyers and sellers on an exchange, is close to the net asset value (NAV) of the securities that constitute the fund. Sometimes, however, the price of the closed-end fund is either higher than its NAV, in which case the fund is said to be trading at a premium, or the fund’s share price is lower than its NAV. In that case, the fund is said to be trading at a discount.
A Three-Way Comparison: CEFs, Mutual Funds and ETFs |
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Opportunities Afforded by the CEF Structure
There are several ways in which the structure of a closed-end fund provides opportunities for investors that other pooled investment vehicles may not be able to offer. The CEF structure also enables managers to pursue certain strategies that provide investors with features they may appreciate. Here are some of those opportunities:
The ability to pay distributions on a regular schedule. Some closed-end funds follow what is known as a managed distribution policy. This means that they use a combination of dividends, interest income, capital gains or a return of capital to pay shareholders a fixed amount of money each month or quarter regardless of the income generated by the fund. The ability to provide a predictable, although not guaranteed, source of income to shareholders on a monthly or quarterly basis may be of great value to many investors.
The ability to use leverage. Closed-end funds may raise additional capital to invest by borrowing money at short-term rates or by issuing preferred stock. Having borrowed money on hand provides flexibility to take advantage of market opportunities. The use of Leverage may also enable CEFs to buy securities that produce higher yields than the cost of the borrowed money. At the same time, however, the use of leverage can add to share-price volatility and risk. The amount of leverage that can be used is subject to regulatory limits under the Investment Company Act of 1940.
The ability to take a long-term investment approach. Unlike mutual fund managers, who must worry about daily inflows and outflows of cash, CEF managers oversee a more stable pool of capital which allows them to maintain a longer-term time horizon when making investment decisions. This characteristic of CEFs becomes most important at times of extreme stress in the public markets when some fund managers are forced to sell securities at depressed valuations due to a high level of redemption requests.
The ability to buy shares below current market value. Because the price of closed-end fund shares is determined by market forces on an exchange, they sometimes differ from the net asset value of its component parts. When the price of the fund is greater than its NAV, the fund is said to be trading at a premium; when the share price of the fund is trading below its NAV, it is said to be trading at a discount. Usually, these variances are minor, with prices generally reverting to the NAV of the fund over time. But for many investors, there is an appeal to buying an asset at a discounted price.
A Variety of CEF Types
To appeal to the needs of investors, the managers of closed-end funds offer a variety of fund types. Many also offer CEFs that pursue a specific investor objective, such as income or growth. Bond funds account for about two-thirds of the assets managed by closed-end funds with equity funds and other funds constituting the remainder.
In the fixed-income area, there are two broad categories of CEFs: Municipal bond funds, which are the largest category of closed-end funds, and taxable bonds. Municipal bond funds invest in bonds issued by state and local governments and agencies and seek to pay out income that is exempt from federal income taxes and, in some cases, also from state and/or local income taxes. Because the municipal bond universe is so diverse, professional managers pay close attention to bond ratings and credit quality. Many of the funds use leverage to enhance their potential for returns. Taxable U.S. bond funds invest in U.S. Treasury securities, issues of government agencies and investment-grade corporate bonds. Some also invest in high-yield bonds.
On the equity side, diversified funds invest in common stocks, usually through a broad mix of companies across many industries and sectors. Some focus on one asset class or investment style, such as large-cap, small-cap, growth, or value. Sector and specialty funds focus on stocks of a specific industry or in niches such as preferred stocks or convertible securities. Like other closed-end funds, they offer professional management and diversification, but in this case in a specialized area.
Global funds mix U.S. and foreign securities in their portfolios, which can include stocks or fixed-income securities. International funds focus exclusively on non-U.S. investments. Some of these specialize in securities of emerging markets. There also are single-country funds.
In many of these fund types, the unique structure of closed-end funds can be an advantage in that during periods of market volatility managers can continue to hold securities in which they see long-term value. Managers also can invest in less liquid securities without having to concern themselves with redemptions. Those benefits may lead to better returns for investors.
To Find Out More
Below are recommended resources for obtaining more information about closed-end funds:
