Friday Jul 25, 2014

What are Closed-End Funds?

1 March 2012

We all know what a mutual fund is – an arrangement in which investors get together, throw a bunch of money into a pot, and hire a professional money manager to buy and sell securities with the money, hoping to make a profit. The manager earns a percentage of the pot for his time and trouble.

Well,  it turns out that there’s a couple of ways to structure a mutual fund – and the two most common are open-end and closed-end funds. On top of that is an opaque veil of commissions and fees, which money managers and investment advisors slap on the customer – but that is a different topic altogether (to learn about the difference between commission based advisors and fee-only advisors, read this article.)

Most of us are familiar with the open-end fund architecture. Here’s how it works: If you want to buy additional fund shares, you send your money into the fund company. The fund company adds your money to the pot, and issues additional shares. The pot gets bigger, and no one else in the fund loses any fund shares. Likewise, when you want to sell your shares, you send your request in to the fund company itself. They typically sell enough securities to raise the cash to send you. (It’s theoretically possible for them to just send you the securities. This is called an ‘in-kind’ distribution. But this is very rare in practice.)

iStock 000017823255XSmall What are Closed End Funds?

Most people accept the arrangement without a second thought. But suppose the fund specialized in a very narrow or comparatively illiquid market. Can you see the problem with this?

If the fund got hit with a lot of redemption requests (or even one large one), they’d have to sell a lot of shares quickly to raise cash. This can depress the price of the security even as you’re selling – and reduce returns for everyone else. Otherwise, the fund will have to hold a portion of the portfolio in cash to meet redemptions. Again, this “cash drag” can hurt returns, since cash doesn’t earn very much. Most managers would rather be invested in something else, most of the time.

That’s where closed-end funds come in. If you own a closed-end fund, you don’t typically buy shares directly from the investment company, nor redeem shares from the company. Instead, you buy them from other investors over the stock exchanges – just like shares of stock! This helps the manager – and other shareholders – because they don’t have to worry about keeping cash around to meet redemptions, and they don’t have to worry about their own trading activity in response to purchases or redemptions distorting share prices. This makes closed-end funds a very useful tool when it comes to investing in smaller or more specialized markets.

Discounts

There’s one other neat feature to closed-end funds – it’s not the stock prices that set the daily price… at least, not directly. Instead, shares are worth whatever other investors are willing to pay for them! Frequently, this means that closed-end shares can be bought for less than their underlying securities are worth if you sold them separately. When this happens, we say the fund is selling at a “discount to NAV,” or a “discount to net asset value.”
Again, this is important – especially for investors looking for income. Why? Because even though the closed-end fund shares sell at a discount to NAV, it doesn’t change the interest or dividend payments coming in. Closed-end funds are therefore great tools for some income-oriented investors. There are no guarantees, though. Just because a fund is trading at a discount to NAV doesn’t mean it’s guaranteed to go up. Discounts could narrow or widen, and fund shares can get cheaper or more expensive.

Exchange Traded Funds

These funds, also called “ETFs,” are essentially index funds packaged like closed-end funds. They have the same structure, basically, as a closed-end fund. But instead of having a manager actively buying and selling stocks and bonds for the portfolio (and collecting a fat percentage!) The ETF portfolio follows an index. That is, it just owns a bunch of preselected securities designed to represent the investment characteristics of the market – whatever that market is. It could be Canadian stocks. It could be U.S. bonds. It could be European equities. It could be oil companies. Whatever it is, you can get ETFs that track nearly anything. Still, keep in mind, nothing can replace good due diligence and research – there are a lot of thinly-traded ETF’s out there, which can turn out to be very illiquid and costly for an investor.

Who They’re For?

I like to use ETFs for long-term holdings because of their low costs and the ease with which you can build a very diversified portfolio. They’re terrifically flexible – and you can buy options on them, too. Which gives you a lot more flexibility as an investor, because you can set limit orders to protect your position, or short-sell them to benefit from a potential market decline.

Both ETFs and closed-end funds are fantastic, too, for wedging into very specialized markets or illiquid markets, while still maintaining some diversity. Examples include emerging markets, gold and precious metals, and funds that concentrate in specific countries, like Singapore.

I also like them for people who tend to buy and hold for long periods of time, and for those who are attracted to dividend income investing in general, when you can buy shares at a significant discount to NAV.

About the Author

Thomas Jensen

Thomas Jensen, owner and managing partner of Vaerdi Financial LLC, grew up in Denmark. He and his wife now live in Portland, OR, with a daughter, a cat and a few ornery chickens that ensure he rises early. Thomas holds a Master of Science degree in Economic Development from University of London and is a graduate of the Certified Financial Planner training program at the University of Portland.

Comments (3 )



Thomas Excellent post! and thanks for the double-mention btw – that was a nice surprise.

DIY investors tend to look the other way with actively managed mutual funds, simply becuase we view the MER (Management Expense Ratios) as a loss in our profits – the average MER in Canada being 2.4% + .1% for trailer fees. Whereas ETF MER’s as you know are much lower.

Based on the idea you mention that managers don’t need to keep a cash reserve and deal with investors who redeem their shares when markets are down. As you mentioned closed end funds get around this problem. Do you think that closed end mutual funds outperform open end mutual funds?

Great post! I will link it up on my weekly lineup :)

Cheers
The Dividend Ninja

[Reply]

Thomas Reply:

Hi Ninja – thanks for the kinds words!
I am a huge fan of ETFs and Index funds myself – for exactly the same reason you mention – costs.
However, not all my clients have the option of using these low-cost investment vehicles – many/most retirement plans don’t give you that option.
Do closed-end funds perform better than open-end funds? Well, theoretically they should. Since a closed-end fund doesn’t have to keep a cash position for redemptions and therefore can stay fully invested, it should earn a higher return. Holding cash is usually a drag on overall yield. Additionally, as I mention, the possibility of buying a closed-end fund at a discount to book value makes it attractive vis-a-vis open-end funds that trade at NAV. There are other reasons that closed-end funds can earn better returns than open-end funds, but that is for another blog post :)

[Reply]

The Dividend Ninja Reply:

Thomas, Look forward to that post!

Cheers

[Reply]

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