Understanding Closed-End Funds

This text is adopted from a brochure entitled "Understanding the Advantages of Closed-End Funds," which is produced by the Closed-End Fund Association (CEFA), the national trade association representing the closed-end fund industry.

Introduction

Closed-end funds (CEFs) are professionally managed investment companies that offer investors an array of potential benefits. While often compared to traditional open-end mutual funds, closed-end funds have many distinguishing features and are, perhaps, more challenging for potential investors to fully comprehend. In addition, they offer investors numerous ways to generate income through portfolio performance, dividends and distributions, and through trades in the marketplace at beneficial prices.

CEF shares are listed on securities exchanges and bought and sold in the open market. They typically trade in relation to, but independent of, their underlying net asset values (NAVs). Intra-day trading allows investors to purchase and sell shares of closed-end funds just like the shares of other publicly traded securities. Net asset value per share (NAV) represents the total value of all assets held by the fund (minus its total liabilities), divided by the total number of common shares outstanding. Market price is the price at which investors may purchase or sell shares of the fund. Market price is determined in the open market by buyers and sellers, based on supply and demand. The fund’s market price fluctuates throughout the day and may differ from its underlying NAV. Shares of the fund may trade at a premium to (higher than) or a discount (lower than) NAV. The difference between the market price and the NAV is expressed as a percentage of NAV.

There is no assurance that a fund will meet its investment objective or that distributions will be made. You could lose some or all your investment. In addition, closed-end fund frequently trade at a discount to their net asset values, which may increase your risk of loss.

Investment Company Industry

Investment companies have been around for over 100 years; however, the foundation for their current popularity was laid with the passage of the Investment Company Act of 1940 (the 1940 Act). This legislation and subsequent amendments and related rules have provided the blueprint for millions of individual investors to obtain professional management of a diversified portfolio of securities at a reasonable cost.

There are two principal types of investment companies: open-end and closed-end.

Open-end funds (more commonly known as mutual funds) continuously offer their shares to investors and prospective investors and stand ready to redeem their shares at all times. Transactions in shares of mutual funds are based on their net asset value (NAV), determined at the close of each business day. Sometimes the transaction price includes an adjustment for a sale , redemption or other charge. NAV is the value of the fund’s assets less its liabilities divided by the number of the fund’s outstanding shares. The invested capital in a mutual fund tends to fluctuate based on investor sentiment.

Closed-end funds have a fixed capital structure and number of shares outstanding, hence the term "closed-end." Following an initial public offering, their shares are traded on an exchange between investors. Transactions in shares of closed-end funds are based on their market price as determined by the forces of supply and demand among investors in the marketplace. Interestingly, the price of a CEF may be above (at a premium to) or below (at a discount to) its NAV. The transaction price will also include a customary brokerage charge. The invested capital in a closed-end fund is fixed and will change only at the direction of management. Capital can be increased through the issuance of shares in conjunction with a rights offering or through the reinvestment of certain fund dividends and distributions. Capital can be reduced when shares of the fund are repurchased in conjunction with a stock repurchase program or tender offer.

Open-end mutual funds Closed-end funds
Similarities
Diversification Both open-end mutual funds and closed-end funds offer investors the potential for diversification through a portfolio of securities that may include many companies, industries, and markets. For individual investors, achieving similar asset allocation would involve building a portfolio of many different investments. (Of course, diversification does not assure a profit and an investor may lose money.)
Professional management Both types of funds offer investors the benefit of active portfolio management by a team of investment professionals. Few individual investors can match the time and effort put in by professionals whose full-time job is to track investments and seek new opportunities.
Economies of scale Money pooled from investor share purchases enable portfolio managers to buy and sell securities in larger quantities with lower costs than would be available for an individual investor.
Differences
Buying and selling shares When an investor wishes to purchase shares of an open-end mutual fund, the fund issues new shares. When an investor wishes to sell shares of an open-end mutual fund, the fund redeems the shares.
The total number of shares outstanding fluctuates as the fund issues and redeems shares.
Similar to a stock, when an investor wishes to purchase or sell shares of a closed-end fund, another investor must be located who wishes to sell or buy these shares.
A closed-end fund issues a fixed number of shares at its initial public offering that generally remains constant. There are methods in which additional shares may be issued or redeemed, but this is at the direction of the fund’s management.
Share price The price that open-end mutual fund shares are purchased and sold by investors is the net asset value of the fund’s assets under management at the close of business that day. The price at which closed-end fund shares are purchased and sold is determined by the market supply and demand of the shares. If demand is high and availability of shares is low, the price of the shares will be at a premium to the fund’s net asset value. Likewise, if demand is low, shares may sell at a discount to the fund’s net asset value.
Liquidity Shares of open-end mutual fund are generally redeemable on a daily basis by the fund’s issuer. A closed-end fund is not required to buy back its shares from an investor upon request. Another investor must be located who wishes to buy the shares.
Shares are purchased and sold on a secondary exchange.

Buying and Selling Closed-End Funds

You will need to set up a brokerage account to buy closed-end funds. Many funds offer a direct purchase plan where an investor can purchase shares from a transfer agent without going through a broker. Investors often place their trade instructions with the assistance of a securities broker, or financial advisor, who transmits instructions to the exchange on which the closed-end fund trades. The broker also may offer guidance on how the fund fits into your overall planning. You can buy or sell closed-end funds through all types of brokerage firms, including full-service brokers, discount brokers and online brokers. In each case, you pay your brokerage firm a commission for the services provided.

The procedures for buying or selling closed-end funds are the same as for buying or selling stocks. Your broker can quote you the current market price of the shares, determined by competitive bidding. You then decide whether you want to pay the prevailing price by submitting a market order or set your own price through a limit order.

The process, from the time you place the order until the confirmation comes back, can take just minutes. This is a major difference between transactions in closed-end fund shares and mutual fund shares:

  • With closed-end funds, you can control the timing of your orders. Through limit orders, you also can control the exact price you pay.
  • With mutual funds, you can't control the timing. All orders received during a business day are filled only at the end of that same day, and all transactions are based on the closing net asset value per share.

Net Asset Value

Net asset value (NAV), which is the value of all fund assets (less liabilities) divided by the number of shares outstanding, is very important in an open-end mutual fund because it is the price upon which all share purchases and redemptions are calculated. For purchases of mutual funds with front-end sales loads, known as "load funds," a brokerage charge generally is added to NAV to determine the purchase price.

Conversely, closed-end fund shares are bought and sold at "market prices" determined by competitive bidding on exchanges and not at NAV. Let's assume that the market price is $18 per share and that NAV is $20. In this case, the closed-end fund sells at a discount of $2 per share. On a percentage basis, the fund sells at a discount of 10% ($2 divided by $20). If the market price is above NAV, say $21 in this case, then the closed-end fund sells at a premium of 5%.

Discounts and Premiums

Ideally there should be no difference between a closed-end fund's share price in the market and its net asset value per share. Thus, there should be no discounts or premiums. However, prices are established by competitive markets which reflect "real world" buying demand and selling supply of shares. In turn, these are influenced by investors' perceptions, fears and need for specific types of investments. Other factors which have been suggested as having an impact on discounts and premiums include: the fund's relative performance, yield, the use of a managed distribution program (guaranteed annual payout of 8%-10%), name recognition of the fund's manager, a significant amount of illiquid holdings in the fund's portfolio and a sizeable amount of unrealized appreciation.

Sources of Financial Information

The market prices of most closed-end funds are reported in the financial pages of daily newspapers. They are shown in the stock exchange (i.e., NYSE, AMEX) listing for each respective fund. Like stocks, each closed-end fund has an identifying ticker symbol which can be useful in locating quotes and trading data.

For investors who wish to obtain the NAV of their fund, most closed-end funds have a website and offer toll-free numbers that provide daily updates. Closed-end fund NAVs are also published in Barron's, The Wall Street Journal and newspapers in major metropolitan areas on a weekly basis.