What is a closed-end fund?
Closed-end funds or CEFs are funds that manage money gathered from a pool of investors. They are known as closed-end funds because they have a fixed number of shares available for trading and do not offer redemptions, meaning investors cannot redeem their shares with the fund administrator. Instead the only way for them to dispose of their shares is in trading markets.
In this respect, they differ from open-end funds, which offer daily redemptions. Open-end funds issue new shares and are frequently rebalanced. The share price for closed-end funds are also more volatile as compared to their open-end counterparts and often trade at a premium or discount to the fund’s net asset value (NAV). Such funds generally trade in secondary markets or over-the-counter (OTC) markets and are favored by investors interested in their distributions, which may be substantial and higher than open-end funds.
Basics of Closed End Funds
The first CEF made its debut in public markets in 1893 and they have been around longer than open-end funds. Their structure is similar to that of open-ended funds: a pool of investors put their money into a basket of equities managed by a professional.
CEFs differ from open-end funds in two respects. First, they have a fixed number of shares outstanding, issued during the initial public offering (IPO) process, in the market. This is unlike open-end funds, which release new shares in the market on a periodic basis. Closed-end funds can only increase the number of shares available for trading through a process known as rights offering in which existing shareholders of the fund purchase the new shares, when they are released into the market.
The second difference between a closed-end fund and an open-ended one is that the former does not offer share redemptions. The only exit ramp available to investors is through trading. Essentially, CEF share owners need to find a buyer for their shares in the markets.
One important point pertaining to CEFs relates to their use of leverage. Unlike their open-ended counterparts, CEFs have access to only a limited pool of capital because they issue a fixed number of shares in the market. They use leverage to maximize returns.
The Investment Company Act of 1940 allows closed-end funds to raise debt equal to 50% of the value of their net assets or issue preferred shares up to 100% of the net amount of assets. The use of leverage leads to volatile price swings for closed-end funds. The average leveraged closed-end funds has 33% leverage, according to investment firm Fidelity.
Why do Investors Put Money into Closed End Funds?
There are three reasons for investors to put money into closed-end funds.
The first reason is the price difference between share prices of closed end funds and their net asset values. Prices for closed-end funds are balanced on two levers: their shares prices and NAV. The former is the price at which they trade on an exchange and the latter refers to the sum total value of the underlying securities contained in the fund.
The share price of a CEF is not related to NAVs. Instead, it is determined by the supply of shares (possibly, finite) and demand for them in the market. Frequently, this price trades at a premium or discount to their NAVs, leaving money on the table for investors. The disparity in prices is attractive to investors, who might be in the market for quick profits.
The second reason for investors to put money into CEFs is income. CEFs have become popular with investors seeking regular income from their investments. Such funds pay out periodic distributions akin to dividends. This income is based on the share’s lower net asset value instead of its market price, which generally trades at a discount to the NAV. The average distribution rate for a closed-end fund is 6%, according to Fidelity. That figure is more than that for other income instruments, such as Treasury bonds.
However, it is important to remember here that the distribution rate can be volatile and vary between periods. The total return, which is the difference between share price return and distribution rate over a longer time-period – generally a year or more, can be a more accurate signifier of a fund’s potential.
The third reason for investors to gravitate towards closed-end funds is the tax advantages from their income. For example, investment in a closed-end fund might be accompanied with tax benefits, if the returns are bond interest gains or return of capital.
Pros and Cons of CEFs
Like open-end funds, closed-end funds offer several advantages to investors. Some of them are listed below:
- Professional expertise: A closed-end fund is managed by an analyst trained to pick stocks. Investors who are not well-versed in this skill get access to experts at a significantly low cost.
- Profit opportunities: The price volatility of closed-end funds can be opportunities to profit for some investors. They can purchase the fund’s shares at a discount and sell it for a premium.
- Liquidity: CEFs have a ready and liquid market available to investors interested in trading their shares.
- Regular income: As mentioned earlier, CEFs can be a source of regular income because they pay out regular distributions that are comparable to other financial instruments, such as government bonds.
Perhaps, the biggest disadvantage of investing in closed-end funds is their volatility. The price swings for a closed-end fund can affect their distribution rates as well as their total return. These variances can occur over the short-term as well as long-term. Daily price swings can affect a closed-end fund’s monthly distribution. When multiplied over a longer time period, those differences can affect a fund’s total return. For example, the one-year return for the Eaton Vance Taxmanaged Global Diversified Equity Income Fund (EXG) is 26.44%. Over three years, it is 9.8%.