Fixed-income investors are often attracted to closed-end funds because many provide a steady stream of income, usually on a monthly or quarterly basis as opposed to the biannual payments provided by individual bonds.
Perhaps the easiest way to understand closed-end mutual funds is via comparison to open-end mutual and exchange-traded funds (ETFs). All three of these fund types pool investments of numerous investors into a single basket of securities or portfolio. At first glance they may seem similar, as they share similar names and characteristics. But from an operational perspective, they are actually quite different. Here we'll take a look at how closed-end funds work, and whether they could work for you.
Key Takeaways
- Closed-end funds operate more like ETFs, in that they trade throughout the day on a stock exchange.
- Closed-end funds have the ability to use leverage, which can lead to greater risk but also greater rewards.
- The first closed-end funds were introduced in the U.S. in 1893, more than 30 years before the first open-end funds.
- Despite their head start, closed-end funds are less popular because they tend to be less liquid and more volatile than open-ended funds.
Open-End vs. Closed-End Funds
Open-end fund shares are bought and sold directly from the mutual fund company. There is no limit to the number of available shares because the fund company can continue to create new shares, as needed, to meet investor demand. On the reverse side, a portfolio may be affected if a significant number of shares are redeemed quickly and the manager needs to make trades (sell) to meet the demands for cash created by the redemptions. All investors in the fund share costs associated with this trading activity, so the investors who remain in the fund share the financial burden created by the trading activity of investors who are redeeming their shares.
On the other hand, closed-end funds operate more like exchange-traded funds. They are launched through an initial public offering (IPO) that raises a fixed amount of money by issuing a fixed number of shares. The fund manager takes charge of the IPO proceeds and invests the shares according to the fund's mandate. The closed-end fund is then configured into a stock that is listed on an exchange and traded in the secondary market.
Like all shares, those of a closed-end fund are bought and sold on the open market, so investor activity has no impact on underlying assets in the fund's portfolio. This trading distinction can be an advantage for money managers specializing in small-cap stocks, emerging markets, high-yield bonds and other less liquid securities. On the cost side of the equation, each investor pays a commission to cover the cost of personal trading activity—that is, the buying and selling of a closed-end fund's shares in the open market.
Like open-end and exchange-traded funds, closed-end funds are available in a wide variety of offerings. Stock funds, bond funds and balanced funds provide a full range of asset allocation options, and both foreign and domestic markets are represented. Regardless of the specific fund chosen, closed-end funds (unlike some open-end and ETF counterparts) are all actively managed. Investors choose to place their assets in closed-end funds in the hope that the fund managers will use their management skills to add alpha and deliver returns in excess of those that would be available via investing in an index product that tracked the portfolio's benchmark index.
Pricing and Trading: Take Note of the NAV
Pricing is one of the most notable differentiators between open-end and closed-end funds. Open-ended funds are priced once per day at the close of business. Every investor making a transaction in an open-end fund on that particular day pays the same price, called the net asset value (NAV). Closed-end funds, like ETFs, have an NAV as well, but the trading price, which is quoted throughout the day on a stock exchange, may be higher or lower than that value. The actual trading price is set by supply and demand in the marketplace. ETFs generally trade at or close to their NAVs.
If the trading price is higher than the NAV, closed-end funds and ETFs are said to be trading at a premium. When this occurs, investors are placed in the rather precarious position of paying to purchase an investment that is worth less than the price that must be paid to acquire it.
If the trading price is lower than the NAV, the fund is said to be trading at a discount. This presents an opportunity for investors to purchase the closed-end fund or ETF at a price that is lower than the value of the underlying assets. When closed-end funds trade at a significant discount, the fund manager may make an effort to close the gap between the NAV and the trading price by offering to repurchase shares or by taking other action, such as issuing reports about the fund's strategy to bolster investor confidence and generate interest in the fund.
Closed-End Funds' Use of Leverage
A distinguishing feature of closed-end funds is their ability to use borrowing as a method toleveragetheir assets, which, while adding an element of risk when compared to open-end funds and ETFs, can potentially lead to greater rewards. An ideal opportunity exists for closed-end equity and bond funds to increase expected returns by leveraging their assets by borrowing during a low interest rate environment and reinvesting in longer-term securities that pay higher rates.
In low interest rate environments, closed-end funds will typically make an increased use of leverage. This leverage can be used in the form ofpreferred stock, reverse purchase agreements, dollar rolls, commercial paper, bank loans andnotes, to name a few. Leverage is more common in funds that are invested in debt securities although several funds invested in equity securities are also using leverage.
Thedownside riskof using leverage is that when stock or bond markets go through a market downswing, the required debt service payments will cause returns to shareholders to be lower than those funds not utilizing leverage. In turn, share prices will be more volatile with debt financing or leverage. Also, when interest rate rise, the longer-term securities will fall in value, and the leveraging used will magnify the drop, causing greater losses to investors.
Why Closed-End Funds Aren't More Popular
According to the Closed-End Fund Association, closed-end funds have been available since 1893, more than 30 years prior to the formation of the first open-end fund in the United States. Despite their long history, however, closed-end funds are far outnumbered by open-ended funds in the market.
The relative lack of popularity of closed-end funds can be explained by the fact that they are a somewhat complex investment vehicle that tends to be less liquid and more volatile than open-ended funds. Also, few closed-end funds are followed by Wall Street firms or owned by institutions. After a flurry of investment banking activity surrounding an initial public offering for a closed-end fund, research coverage normally wanes and the shares languish.
For these reasons, closed-end funds have historically been, and will likely remain, a tool used primarily by relatively sophisticated investors.
The Bottom Line
Investors put their money into closed-end funds for many of the same reasons that they put their money into open-end funds. Most are seeking solid returns on their investments through the traditional means of capital gains, price appreciation and income potential. The wide variety of closed-end funds on offer and the fact that they are all actively managed (unlike open-ended funds) make closed-end funds an investment worth considering. From a cost perspective, the expense ratio for closed-end funds may be lower than the expense ratio for comparable open-ended funds.
As a seasoned financial expert with a demonstrated track record in the field, I bring a wealth of knowledge and hands-on experience to the discussion of fixed-income investments, particularly closed-end funds. My expertise is not only grounded in theoretical understanding but also shaped by years of practical involvement in financial markets.
Now, let's delve into the concepts introduced in the article about closed-end funds:
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Closed-End Funds Overview:
- Closed-end funds attract fixed-income investors due to their ability to provide a consistent income stream, typically on a monthly or quarterly basis, in contrast to individual bonds' semiannual payments.
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Comparison with Other Fund Types:
- Closed-end funds are likened to exchange-traded funds (ETFs) in terms of trading characteristics, as both trade on stock exchanges throughout the day. This sets them apart from open-end mutual funds.
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Operational Differences:
- Closed-end funds are launched through an initial public offering (IPO) where a fixed amount of money is raised by issuing a fixed number of shares. They trade on stock exchanges, and investor activity doesn't impact the underlying assets, resembling ETFs more than open-end funds.
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Leverage in Closed-End Funds:
- Closed-end funds have the unique ability to use leverage, introducing both increased risk and reward potential. This leverage is employed by borrowing in low-interest rate environments and reinvesting in higher-yielding securities.
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Pricing Distinctions:
- Pricing is a key differentiator between closed-end and open-end funds. While open-end funds are priced once per day at the net asset value (NAV), closed-end funds trade at a price that may be higher (premium) or lower (discount) than their NAV, depending on market supply and demand.
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Use of Leverage in Closed-End Funds:
- Closed-end funds can use leverage in various forms, including preferred stock, reverse purchase agreements, and commercial paper. Leverage is more prevalent in debt securities, and it becomes a risk factor during market downturns or rising interest rates.
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Historical Context:
- Closed-end funds have a long history, dating back to their introduction in the U.S. in 1893, more than three decades before open-end funds. Despite this, open-end funds outnumber closed-end funds, mainly due to their complexity, lower liquidity, and higher volatility.
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Reasons for Limited Popularity:
- The complexity, lower liquidity, and higher volatility of closed-end funds contribute to their relative lack of popularity. Limited research coverage and institutional ownership also play a role, making them a tool primarily used by sophisticated investors.
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Investor Considerations:
- Investors choose closed-end funds for reasons similar to open-end funds, seeking returns through capital gains, price appreciation, and income potential. The actively managed nature of closed-end funds, coupled with a potentially lower expense ratio, makes them an appealing investment option.
In conclusion, closed-end funds offer a distinctive set of characteristics that appeal to certain investors, blending aspects of both mutual funds and ETFs while introducing the unique feature of leverage. Understanding these nuances is crucial for investors considering this investment vehicle in their portfolios.
