Closed-end funds

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Closed end funds are registered investment companies. Other forms of the registered investment company include mutual funds, exchange traded funds, and unit investment trusts. As of year-end 2018, a total of 506 U.S. closed end funds held over 250 billion dollars of assets. An estimated 3.6 million American households were invested in closed-end funds. [1] [note 1]

Characteristics

A closed-end fund, similar to other registered investment companies, represents a pooled investment vehicle that holds investment securities, such as stocks and bonds and other securities. Closed-end funds are actively managed portfolios, which, like mutual funds, possess a net asset value (NAV). Unlike open-end mutual funds however, which issue and redeem fund shares directly to investors, a closed end fund raises capital through an initial public offering (IPO) and is then listed on a national exchange such as the New York Stock Exchange (NYSE) or the NASDAQ. The fund is then bought and sold from other investors just like any other stock. The fund trades at its market price, which may be at a discount or premium to its NAV according to the dictates of supply and demand for the shares. The table below outlines some of the basic comparative features of open-end and closed-end funds [2]:

Open-End Funds vs. Closed-End Funds [3]
Characteristic Open-End Mutual Funds Closed-End Funds
Purchase price End of day NAV Market price set by supply and demand
Prices change Daily – close of business Intra-day
Transaction prices include Sales, redemption charges Standard commission
Shares sold to/purchased from Fund company Secondary market (NYSE, AMEX)
Shares offered by fund company Continuously Primarily at IPO


Creation of shares

Closed-end shares are initially created by an initial public offering. Additional shares may be created by dividend and capital gains distributions being reinvested into the fund, and by a fund issuing rights for new share issuance. Rights offer current shareholders the right to purchase new shares, usually at a discounted price, in proportion to the shareholder's current ownership stake in the fund. The shareholder can exercise her rights by purchasing the shares, or, if the rights are transferable, selling her rights on the market.

Premiums and discounts

HISTORICAL CLOSED-END FUNDS DAILY AVERAGE PREMIUM/DISCOUNT (12/5/07 — 9/30/09) Claymore CEF Index‎

The fact that a closed-end fund trades on the open market results in a fund's market price moving independently of a fund's net asset value. If the price is lower than net asset value, the fund is said to be trading at a discount; if it trades at a price higher than net asset value, the fund is said to trade at a premium. Premiums and discounts fluctuate. In general, it can be attractive to purchase a fund at a discount to NAV, since doing so allows one to receive a higher yield from the purchase than one would receive if buying at NAV. One major caution about purchasing a closed-end fund initial public offering is that the fund's market price will almost invariably drop to a discount once the underwriters stop supporting the offering. [4]

Astute investors, after examining a fund’s investment objectives and the quality of fund management, tend to prefer to buy closed-end funds at discount to NAV. In seeking good value an investor should analyze the discount according to three factors:

  • The size of past discounts (the deeper the current discount the better)
  • Discounts on competing portfolios (the deeper the current discount the better)
  • The fund’s expense ratio

Fredman and Wiles in How Mutual Funds Work, suggest that dividing the discount by the expense ratio provides a good metric of relative value, with ratios over 10 suggesting good value. [5]

Discount/Expense Ratio [6]
Fund Discount % Expense Ratio % Discount/Expense Ratio
Fund A 25 3.0 8.33
Fund B 20 2.5 8.0
Fund C 10 0.4 25.0

The effect of buying a fund at a premium to net asset value, and having the fund fall into a discount can be seen in the following table:

Buying at a Premium
Fund Original Price Current Price Change
Net Asset Value 10.50 8.50 -19.05%
Market Price 12.50 7.50 -40.00%
Premium/Discount 19.05% -11.76%

Expenses

Closed-end funds do not have the sales charges associated with open-end load funds, nor do they have 12b-1 distribution fees. One must, however, pay brokerage commissions and spread costs when purchasing a closed-end fund on an exchange. Closed-end funds, like mutual funds, also have an expense ratio. Many closed-end funds employ leverage, and the expense ratio of a leveraged fund will include the interest cost of the borrowed funds. In general, closed-end funds are not low-cost vehicles, as the following table demonstrates:

Closed-End Fund Expenses (2010)
Expense Ratio Number of Funds
2.01 + 159
1.50 - 2.00 134
1.00 - 1.50 283
0.50 - 1.00 67
0.50 or less 7

Leverage

More information on Closed-end fund leveraging:

One major difference between open-end mutual funds and closed-end funds is in the capital structure of the funds. In addition to common stock, the Investment Company Act of 1940 permits closed-end funds to issue preferred stock. Preferred stock differs from common stock in that preferred shareholders are paid dividends and have priority to income and assets of the fund on liquidation but do not share in the gains and losses of the fund. The funds can also use other means of leveraging such as borrowing money or issuing debt securities. The Investment Company Act of 1940 sets asset coverage requirements for closed-end funds. For each $1 dollar of debt issued, the fund must have $3 of assets immediately after issuance and at the time of dividend declarations (commonly referred to as 33% leverage). Similarly, for each $1 of preferred stock issued, the fund must have $2 of assets at issuance and dividend declaration dates (commonly referred to as 50% leverage). [7] Approximately 72% of closed-end funds employ leverage. [8]

Up until February 2008, closed-end funds mostly issued auction market preferred stock (AMPS), a type of preferred share that pays dividends at rates set through auctions. Typically, dividend rates are reset through auctions that are held every seven or 28 days. In February 2008, the auction markets failed, and since then auction market preferred stock is no longer issued. The funds have used other means of leveraging including an attempt to establish a new type of preferred stock, puttable preferred stock, as a funding instrument. [9]

A fund's reported effective leverage percentage will include not only the capital structure leverage (statutory) but also the leverage provided by the fund manager's use of derivative products (portfolio).

Funds employ leverage to enhance the portfolio's yield. Leverage works to the advantage of the fund when the yield curve is upward sloping and steep, and when the difference between short term rates and long term rates is high. When the yield curve flattens or inverts, leverage works to the detriment of the fund. The leverage increases the fund's volatility of returns.

Managed distribution policy

"Distribution Yield: Total 12-month cash payments per share, divided by ending market price (or NAV, as appropriate). Such payments may include unknown combinations of income, short- and long-term capital gains, and return of capital. Commonly known as Market (NAV) Yield. This should not be considered the equivalent of total return performance calculations. Yield figures are as of most recent month-end.

Income Only Yield: Based upon the latest annual report, net investment income (NII) for common shares (after subtraction of dividends paid on preferred shares) in full dollars, divided by average net assets (ANA) in full dollars, expressed as a percentage; it does not include return of capital. Thus, $2.2mm NII on $100 MM ANA would be 2.2%. Yield figures are as of most recent month-end. "

-- CEFA:Data Definitions


Managed distribution policies are available to closed-end funds through an application to the SEC for exemption under the Investment Company Act of 1940. Approximately 6% of closed-end funds employ a managed distribution policy. [10] Generally, a fund adopting a managed distribution policy attempts to make relatively predictable, steady cash flows to investors based upon a projected long term return assumption for the fund. The distributions can be either a static amount per common share, or a percentage of the fund's recent or average net asset value. The distributions are made from the following components:

  • net investment income
  • a portion of short term and long term gains
  • return of capital

The most commonly cited motivation for a fund's adopting a managed distribution policy is that such a payout policy may reduce a fund's discount to net asset value. [11] [12]

Due to the redistributed capital distributions included in the distribution yield of a closed-end fund, it should not be confused with the net investment yield of the fund. [13]

Closed end fund categories

Because a closed-end fund is not subject to investor flows into or out of the portfolio, fund managers are more likely to remain fully invested in comparison to mutual fund managers. The SEC also allows a closed-end fund to invest in a greater amount of illiquid securities than can mutual funds. [14] Closed-end funds are usually grouped into four main categories:

  • US Tax-exempt fixed income
  • US Taxable fixed income
  • Global/Non-US fixed income
  • US equity
  • Global/Non US equity

In 2008 closed-end funds were comprised of 60% fixed income funds and 40% equity funds. The industry had greater equity fund issuance from the years 2004- 2008. The following table shows the distribution of closed-end funds across the major asset classes:

Closed-End Fund Distribution Across Asset Classes (2018) [15]
Asset Class Percentage of all Funds
US Tax-exempt bonds 35%
US Taxable bonds 21%
US equity 27%
Global/Non-US equity 9%
Global/fixed 8%

Tax exempt bonds

Main article: Municipal bonds
Annette Thau: Advice on When to Buy:
  • Never buy a fund at issue.
  • Only buy if the fund its trading at a wide discount to net asset value; that would also be at a time when its yield would be particularly attractive.
  • One variation of this piece of advice is to track the discount pattern of a fund, and only buy it if its discount is wider than the normal discount. Sell when the discount narrows."
-- Annette Thau, An Investor's Guide to Closed-End Muni Funds, AAII Journal, September 2006


Tax-Exempt bond funds comprise the largest segment of the closed-end fund universe. Portfolios include national municipal bond funds, high yield municipal bond funds, and municipal bond funds covering 17 individual states.

State Municipal Closed-end Bond Funds
State State

Arizona
California
Connecticut
Florida
Georgia
Maryland
New Jersey

New York
North Carolina
Ohio
Pennsylvania
Texas
Virginia

Almost 95% of the funds are leveraged, with a typical effective leverage of around 30% of the total net assets of a fund. By borrowing funds at lower short term rates and investing in higher yielding longer term bonds, a fund can increase its yield, although at a greater risk of increased volatility of capital. Leverage works to the advantage of the fund when the yield curve is upward sloping and steep, and when the difference between short term rates and long term rates is high. When the yield curve flattens, leverage works to the detriment of the fund. Thus, in situations where short term rates rise (increasing borrowing costs) or long term rates rise (falling NAV), a fund may find itself facing:

  • having to cut the dividend;
  • seeing the NAV fall;
  • investor sales causing the market price of the fund to fall. [16]

If a closed end fund has a managed distribution policy, the yield distribution can include capital gains and return of capital distributions in addition to a distribution of net investment income. Funds are required to publish income ratios (net investment income divided by net asset value) but this figure will differ from the published "yield" one sees based on market price.

Taxable bonds

Closed-end funds invest in a wide range of taxable fixed income securities, including investment grade corporate bonds, high yield corporate bonds, mortgage securities, convertible bonds, preferred securities, master limited partnerships, and senior loan participation funds. A limited number of closed-end funds invest in inflation indexed bonds. Most funds employ leverage.

Government bonds

Main article: Mortgage-backed security

U.S. Mortgage Funds (USM) - invest primarily in mortgages/securities issued or guaranteed as to principal and interest by the U.S. government and certain federal agencies. [17]

Corporate bonds

Main article: Corporate bonds
  • Corporate Debt Funds BBB-Rated (BBB) - invest primarily in corporate and government debt issues rated in the top four grades. [17]
  • General Bond Funds (GB) - do not have any quality or maturity restrictions. These funds intend to keep the bulk of their assets in corporate and government debt issues. [17]
  • High Current Yield Funds (HY) - aim at high (relative) current yield from fixed income securities, have no quality or maturity restrictions, and tend to invest in lower-grade debt issues. [17]
  • High Current Yield Funds (Leveraged) (HYL) - aim at high (relative) current yield from fixed income securities, have no quality or maturity restrictions, and tend to invest in lower-grade debt issues. These funds can be leveraged via use of debt, preferred equity, and/or reverse repurchase agreements. [17]

Convertible bonds

Main article: Convertible bonds

Invest primarily in convertible bonds and/or convertible preferred stock.

Preferred securities

Main article: Preferred stock

Invest primarily in preferred securities, often considering tax code implications.

Senior loans

Loan Participation Funds (LP) - invest primarily in participation interests in collateralized senior corporate loans that have floating or variable rates. [17]

Domestic equity

Main article: Stock basics

Covered call strategies

Global/international equity

Main article: Domestic/International

Global/international bonds

Main article: Developed market bonds

Notes

  1. ↑ ICI: Factbooks
    Number of CEFs and Total Net Assets (Billions of Dollars)

    (View Google Spreadsheet in browser, then File --> Download as to download the file.)
    Note: If the spreadsheet is blank, select a different sheet, then back to that sheet. The image will be refreshed.

References

  1. ↑ ICI Mutual Fund Factbook 2019, pp.50-56.
  2. ↑ CEF Connect: What is a CEF?
  3. ↑ Closed-End Fund Research Industry Report, Edward James, (June 30, 2009)
  4. ↑ Annette Thau, An Investor's Guide to Closed-End Muni Funds, AAII Journal, September 2006
  5. ↑ Albert J. Fredman and Russ Wiles, (1998) How Mutual Funds Work, Prentiss Hall Inc., ISBN 0-13-839721-X
  6. ↑ Albert J. Fredman and Russ Wiles, (1998) How Mutual Funds Work, Prentiss Hall Inc., ISBN 0-13-839721-X
  7. ↑ ICI: Frequently Asked Questions About Closed-End Funds and Their Use of Leverage
  8. ↑ CEFA: Leveraged Funds
  9. ↑ ICI: Frequently Asked Questions About Closed-End Funds and Their Use of Leverage
  10. ↑ CEFA: Funds with Managed Distribution Policies
  11. ↑ Wang, Zhi Jay and Nanda, Vikram K., Why Do Aggressive Payout Policies Reduce Fund Discounts - Is It Signaling, Agency Costs, or Dividend Preferences? (March 4, 2008). AFA 2009 San Francisco Meetings Paper. Available at SSRN: http://ssrn.com/abstract=1102715
  12. ↑ Cherkes, Martin, Sagi, Jacob S. and Wang, Zhi Jay, A Neoclassical Model of Managed Distribution Plans: Theory and Evidence (November 15, 2009). Available at SSRN: http://ssrn.com/abstract=1517004
  13. ↑ CEFA:Funds with Managed Distribution Policies
  14. ↑ SEC: Closed-End Funds
  15. ↑ ICI Mutual Fund Factbook 2019, pp.50-56.
  16. ↑ Annette Thau, An Investor's Guide To Closed-end Muni Funds, AAII Journal, September, 2006, pp.7-8.
  17. ↑ 17.0 17.1 17.2 17.3 17.4 17.5 CEFA:Description of Classifications

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