What Is A Closed End Fund? How It Differs From Open End Fund

What is a Closed End Fund

CEFs, or closed-end funds, have been around for almost a century. CEF shares are traded on the open market. CEFs, like stocks, are launched in an initial public offering. They are invested in a security portfolio that is managed by an investment firm. Unlike traditional mutual funds, no new money is invested in these funds; instead, investors buy and sell existing shares. CEFs, like exchange-traded funds, invest in a wide range of securities, including equities, bonds, and alternative investments. Let’s look at how closed end fund works and how it differs from open end fund.

What is a Closed-End Fund?

A closed-end fund is a publicly traded investment business that invests in stocks and bonds. According to the firm’s investing objectives, the fund raises capital largely through an initial public offering (IPO). The term “closed” refers to the fact that, once the capital has been raised, there are normally no more shares available from the fund sponsor, and the issue of new shares to investors is closed.

Most closed-end funds are listed on a national exchange after their initial public offering (IPO), such as the New York Stock Exchange (NYSE) or the NASDAQ. The fund’s shares are bought and sold via transactions with other investors rather than with the sponsor firm.

A typical closed-end fund strategy is an actively managed portfolio of securities. These securities assets add up to a value known as the fund’s Net Asset Value (NAV), which may differ from the fund’s market price. The market price is decided by market demand and supply, not by the net asset worth of the fund.

Because most closed-end funds make regular monthly or quarterly distributions, demand is frequently connected to both the distribution amount and the fund’s NAV performance.

Although a closed-end fund’s existing shares remain essentially stable, extra shares can be produced through secondary offerings, rights offerings, or the issue of shares for dividend reinvestment.

How Does Closed-End Fund Work?

A closed-end fund, like many mutual funds, has a professional manager who oversees the portfolio and actively buys, sells, and holds assets.

Its shares, like any other stock or ETF, fluctuate in price throughout the trading day. However, the parent company of the closed-end fund will not issue additional shares, and the fund will not buy back shares.

Many parallels exist between the closed-end fund and open-end mutual funds. Both make income and capital gain distributions to their shareholders. For their services, both charge an annual expense ratio. Furthermore, the firms that provide them must be registered with the Securities and Exchange Commission (SEC)

The Fundamentals of Closed-End Funds

These four concepts are critical to comprehend the worth of closed-end funds:

  • Portfolio – The CEF structure gives you access to a diverse portfolio of investments, including alternatives.
  • Fund structure and leverage – To maximize return and distribution possibilities, many CEFs use modest financial leverage.
  • Stock exchange listing – Share values are determined by supply and demand.

Why Are They Referred to as “Closed-End” Funds?

A CEF, like a standard mutual fund, invests in a portfolio of assets and is often managed by an investment management firm. However, unlike mutual funds, CEFs are closed in the sense that capital does not flow into them on a regular basis when investors buy shares and does not flow out when investors sell shares. Shares are not traded directly with the sponsoring fund family after the initial public offering (IPO), as is the case with open-end mutual funds.

Instead, shares are often traded on an exchange, with other market players acting as the corresponding buyers and sellers. The fund does not issue or redeem shares on a daily basis. CEFs, like stocks, have an initial public offering when they first go public. The capital obtained during the IPO is then used by the portfolio managers to purchase securities that suit the fund’s investment strategy.

5 Ways Capital Can Flow Out of a CEF

  • Dividends to shareholders
  • Poor investment choices
  • A tender offer to repurchase shares as a means of controlling discounts
  • For leveraged funds only, forced sales to stay within leverage limits.
  • The fund’s liquidation

Because capital does not freely flow into and out of CEFs, they are known as “closed-end” funds.

Discounts and premiums are created through the “closed-end” structure. Following the IPO, a CEF’s shares trade on the open market, often on an exchange, and the share price is determined by the market. As a result, the share price may not always correspond to the net asset value of the fund’s underlying holdings. (Net asset value = (fund assets – fund liabilities) / outstanding shares)

When the share price exceeds the net asset value, the shares are considered to be trading at a “premium.” This is commonly referred to as a “positive discount,” which is mathematically incorrect. A fund trading at a 2% premium, for example, might be denoted as “+2%.” The shares are said to be trading at a “discount” if the share price is less than the net asset value. This is usually represented with a minus sign, as in “-2%.”

The Closed-end Structure’s Implications

A closed-end fund manager, unlike an open-end mutual fund manager, does not experience reinvestment risk from the daily share issues.

A closed-end fund management is not required to keep surplus capital in order to meet redemptions.

The capital is regarded as more solid than in open-end funds because there is no need to generate cash fast to accommodate unexpected redemptions. It has a consistent capital basis.

In turn, the relatively steady capital base gives rise to two further characteristics:

For starters, it makes CEFs an excellent vehicle for investing in illiquid securities such as emerging-markets stocks, municipal bonds, and so on. The higher risk of investing in illiquid securities may result in larger returns to owners.

Second, authorities permit the funds to issue debt and preferred shares with strict leverage restrictions. The fund has the authority to issue debt up to 50% of its net assets. Another way to look at it is that the fund must have $3 in assets for every $1 in debt (including the assets from the debt). This is often known as a 33% leverage limit.

The fund can issue preferred stock worth up to 100% of its net assets. Another way to look at it is that the fund must have $2 in assets for every $1 in preferred shares issued (including the assets from the preferred shares). This is generally known as a 50% leverage limit.

The idea is that CEFs are not extremely leveraged, however, any amount of leverage accentuates the fund’s net asset value volatility.

How Might Closed-End Funds Provide More Income and Diversification?

#1. A bigger investing universe

Closed-end funds (CEFs) can invest in specialized, less liquid markets that open-end funds cannot, such as alternative securities, real estate, and private placements. They allow individual investors to acquire exposure to assets that they would not be able to access otherwise. However, certain sorts of securities may be more dangerous.

#2. Leverage

CEFs have more freedom than open-end funds to use leverage in their strategies. Leverage, or borrowing to increase investment exposure and possible possibilities, usually magnifies investment returns, resulting in higher highs and lower lows. 1 It has traditionally increased income more than enough to compensate for its additional cost and volatility over longer time periods.

#3. Professionally run

CEFs are actively managed with the purpose of generating consistent and predictable payments to shareholders. Product managers are responsible for smoothing income streams and managing payouts.

#4. Exchanged Traded

CEFs are traded on exchanges, and the value of their shares is decided by supply and demand. Shares frequently trade at a discount to the fund’s net asset value, allowing investors to invest at a “deal.” This distinct feature of CEFs gives investors greater choice over when and at what price they acquire and sell their shares.

Net Asset Value (NAV) and Closed-End Funds

One of the distinguishing features of a closed-end fund is its price. The fund’s NAV is computed on a regular basis depending on the value of the fund’s assets. However, the price at which it trades on the exchange is determined by the market. This means that a closed-end fund might trade at a premium or at a discount to its net asset value (NAV). (A premium price is one that is higher than the NAV, whereas a discount is one that is lower than the NAV.)

This is due to a number of factors. The market price of a fund may climb because it is focused on a popular sector among investors at the time, or because its manager is well-regarded among investors. Alternatively, a track record of underperformance or volatility may make investors apprehensive of the fund, causing its share price to fall.

Closed-End Fund Performance

Closed-end funds do not buy back their investors’ shares. This means companies don’t have to keep a significant cash reserve, giving them more money to invest.

They can also employ leverage (borrowed money) to increase their returns.

As a result, closed-end funds may be able to provide higher total returns than open-fund mutual funds.

Examples of Closed-End Funds

Municipal bond funds are the most popular type of closed-end fund in terms of assets under management. These huge funds invest in state and municipal government debt as well as federal government agencies’ debt. These funds’ managers frequently seek extensive diversification to reduce risk, but they may also rely on leverage to increase profits.

Managers also create closed-end global, international, and emerging markets funds that invest in both stocks and fixed-income funds. (Global funds invest in both domestic and international equities.) International funds only invest in non-US equities. Emerging market funds invest in rapidly expanding and volatile international sectors and areas.)

The Eaton Vance Tax-Managed Global Diversified Equity Income Fund is one of the largest closed-end funds (EXG). It was founded in 2007 and had a market capitalization of $2.5 billion as of June 2022. 2 The primary investing goal is to produce current income and gains, with capital appreciation as a secondary goal.

What Are the Benefits of Investing in a Closed-End Fund?

A closed-end fund can be used to make money in two ways: You can benefit from the income or growth generated by the fund’s investments. You may also be able to purchase shares of the fund at a discount to its net asset value (NAV).

The NAV of an open-end mutual fund is calculated as the real current worth of the fund’s investments. A closed-end fund’s shares trade on a stock exchange throughout the day, and its market-driven price may fluctuate from its NAV.

How Do Closed-End Funds Differ From Open-End Funds?

When an investor decides to invest in an open-end mutual fund, it creates new shares and buys them back when they become available.

A closed-end fund only issues shares once. The only option to later join the fund is to purchase some of the existing shares on the open market.

Closed-end funds, in particular, frequently employ leverage, or borrowed money, to improve their returns to investors. That means more potential gains in good times and greater potential hazards in bad.

Fees are one thing that both closed-end and open-end funds have in common. When compared to index funds and ETFs, most closed-end funds are actively managed and demand relatively high fees.

Closed-End Fund FAQs

Are closed-end funds a good investment?

Investing in closed-end funds, in general, provides substantially higher income potential but might result in significant market volatility, poorer overall returns, less predictable dividend growth, and the possibility of unexpected surprises.

What is difference between open and closed-end funds?

While open-end funds can be bought and sold at any time, closed-end funds can only be purchased at the time of their introduction and redeemed when the fund’s investing term expires.

Are closed-end funds good for retirement?

Closed-end funds have emerged as a possible answer for retirees looking to smooth out their cash flows and, as a result, calm their anxiety. Closed-end funds may be appealing to agitated retirees looking for consistent dividends.

References

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