A closed-end fund is a unique investment vehicle. Though it has certain similarities with traditional mutual funds — which are commonly open-end funds — as well as with exchange-traded funds (ETFs), a closed-end fund operates in a totally different manner.
The unique differences inherent to closed-end funds can increase your potential risk or reward. If you’re interested in investing in these funds, you’ll need to know as much about them as possible – both to increase the likelihood of positive performance, and to minimize the risk of loss.
The Basics of a Closed-End Fund
A closed-end fund is an investment fund that has a limited number of shares to sell to investors. The number of shares is fixed at the initial public offering (IPO) of the fund and never increases. This is radically different from open-end funds, which have no limit on the number of shares they can issue.
Closed-end funds do have a net asset value (NAV), but the market price can vary significantly from that value. That’s because they trade at either premiums or discounts to their respective NAVs.
Closed-end funds are also actively managed, which means they hold the potential to both outperform the market — which is management’s intention — or underperform it. As a result of this active management, closed-end funds usually charge higher fees than other types of investment funds.
What happens if you want to sell your closed-End funds?
If you’re planning to invest in closed-end funds, the fund will not redeem the shares if you decide to sell Much like a stock trading on the open market, your ability to sell the shares in the fund is dependent on there being a willing buyer. This can make them less liquid than open-end funds and exchange-traded funds (ETFs).
Despite those limitations, closed-end funds do have the real potential to outperform mutual funds, ETFs and the general market. This is the reason why people invest in them, though the market for these funds is admittedly lower than it is for other funds.
Open vs. Closed-End Funds
Open-end funds and closed-end funds have a lot of similarities. For example:
- Each is a portfolio of securities that are professionally managed. Though open-end funds can be either actively managed (that is, they attempt to outperform the market through active trading) or index funds (which track an underlying index, like the S&P 500), closed-end funds are purely actively managed funds.
- Each also trades based on share price, which can change on a daily basis. Both have the potential to generate income from dividends, as well as capital gains and losses on buying and selling shares of companies held within the fund.
That’s pretty much where the similarities between the two fund types end. For the most part, they are very different investment vehicles.
Differences Between Open and Closed-End Funds
- The major difference between closed-end funds and open-end funds is in the number of shares issued. As discussed above, closed-end funds offer only a limited number of shares. This number is determined when the fund is launched.
- By contrast, open-end funds have no limit on the number of shares they can issue – which is where the term “open-end” comes from. Open-end funds can also sell as many shares as it has investor demand for.
- Another significant difference is share price. While closed-end funds can trade at a discount or a premium, open-end funds trade at their net asset value. And while they funds don’t repurchase shares from investors, open-end funds do so routinely. Both the buying and selling of open-end shares are done through the fund, rather than on the open market.
- Closed-end funds are also more likely to hold alternative investments. These can include derivatives, foreign currencies, or even futures. And since they trade more actively, closed-end funds are likely to have higher expense ratios than open-end funds.
How Closed-End Funds Work
Closed-end funds tend to be more specialized investment funds. For example, rather than investing in the general market, they’ll concentrate on a specific industry sector like healthcare or technology, or a geographic market like international stocks.
Closed-End Funds’ Share Price
Much like other funds, closed-end funds have a regularly tracked NAV that’s based on the value of the portfolio, divided by the number of shares issued by the fund. But because of the limited number of shares available, they can trade at values that are either higher or lower than the NAV. This results in premiums above the NAV if demand is high, or discounts to the NAV if demand is weak. In that way, closed-end funds are subject to investor demand for the fund shares, more so than their underlying NAV.
If you want to invest in a closed-end fund, you’ll need to purchase it at a discount through a broker account. That will increase the likelihood of being able to sell it for a profit. But if you pay a premium above the NAV, you’ll be more likely to lose money on the transaction.
Use of Leverage
Part of the reason closed-end funds often have higher returns than their open-end cousins is that they frequently use leverage to increase returns. For example, a closed-end fund may borrow money to purchase stocks. That strategy will increase returns when the market is rising but magnify losses in a downturn.
For example, let’s say a fund invests $1 million in stock of Walmart, and borrows an additional $1 million to purchase more shares. The return on investment after one year may be 20% (less borrowing costs), rather than 10% if leverage had not been used.
Going in the other direction, if the same purchase set up was used — 50% fund capital and 50% borrowed funds — and the value of the Walmart stock fell by 10%, you’d experience a 20% loss on your investment (plus borrowing costs), rather than a 10% loss if leverage had not been used.
For this reason, closed-end funds are best suited to investors who have a high-risk tolerance and are willing to endure the possibility of an investment going in the wrong direction.
In either case, a closed-end fund will typically pay out higher dividends than open-end funds because of the use of leverage, whether the value of the stock rises or falls. If your investment in the fund would pay $2,000 in dividends on an unleveraged position, you would instead receive $4,000 when leverage is used.
Buying Closed-End Funds
If you plan to invest in closed-end funds, it’s best to do so through a brokerage account. The broker should also specialize in mutual funds. The more they offer, the more likely it is they’ll also offer closed-end funds in the mix, since closed-end funds are much less common than open-end funds. Here are our tips on how to choose an online stock broker.
Once again, the best advice in buying closed-end funds is to buy the fund at a discount to its NAV. You can determine this by comparing the current market price to the NAV, which is calculated by dividing the value of the portfolio by the number of shares issued. You should look for a discount of at least 10%, which will give you a built-in profit if the share price rises just to its NAV level. And, of course, the profit will be even higher if the fund begins to trade at a premium. This can give you the benefit of both the increase in the NAV of the fund, as well as the shift from discount to premium. It’s just another example of how closed-end funds often deliver higher returns than open-end funds.
As with any type of fund, you’ll have to closely examine its long-term performance. Investing in closed-end funds isn’t as simple as buying at a discount and selling at a premium. The performance of the fund itself, and of its NAV, are of even greater importance. After all, the better the performance of the fund, the more interest there will be from investors, increasing the likelihood of the share price rising to a premium level.
When analyzing a closed-end fund, look closely at the debt ratio the fund typically uses. If it approaches 50%, the fund will be extremely risky, even if the profit potential is greater. You’ll need to consider your own risk tolerance when deciding whether to invest in riskier funds.
Are ETFs Closed-End Funds?
The short answer is no. A closed-end fund is not an exchange-traded fund, and it’s not even a traditional (open-end) mutual fund.
Much like traditional mutual funds, ETFs do share certain common characteristics with closed-end funds. For example, both are pooled investment funds that invest in a portfolio of individual securities. Each also has its own NAV, and trades on exchanges at prices that vary continuously. Each also has expense ratios, pays distributions of dividends and capital gains (or losses), and can be purchased through brokerage firms. And like a closed-end fund, there are a small number of ETFs that also use leverage in their investing activities.
But from an investment standpoint, ETFs are a completely different animal from closed-end funds.
For example, like open-end mutual funds, ETFs have no limit on the number of shares they can offer. They also trade at their NAV and are not subject to premiums and discounts.
The biggest difference between the two is that while closed-end funds are actively managed, the vast majority of ETFs are passively managed as index funds. That means their performance is specifically tied to an underlying index. This investment methodology also minimizes capital gains, since securities are neither bought or sold unless the composition of the underlying index changes.
Learn more >>> How to Invest in ETFs
The Best Closed-End Funds
There is no guarantee that any investment will produce positive returns. After all, it’s impossible to predict the future. But if you’re looking to invest in closed-end funds, you gotta start somewhere. Here are some examples of closed-end funds that have performed rather well of late:
- Voya Emerging Markets High Dividend Equity Fund (IHD): This fund concentrates on dividend-paying securities in emerging markets.
- Aberdeen Total Dynamic Dividend Fund (AOD): The fund concentrates on companies with high dividend yields, but also with the potential for capital growth. The fund includes a mix of some of the best-known companies in their respective industries.
- PIMCO High Income Fund (PHK): This is a fixed income fund that draws securities from diverse sectors. The emphasis in the fund is on current income, but also on capital appreciation. One factor to be aware of is that the fund does invest in low-grade, high-yield bonds.
This list is not a recommendation to invest in any of these funds. Instead, it’s an example of closed-end funds that are available. Be sure to do your research, favoring funds that sell at a discount and have a good long-term performance.
Pros and Cons of Closed-End Funds
- Potentially higher returns due to active management and use of leverage.
- Increased likelihood of positive returns when purchased at a discount.
- Closed-end funds typically invest in more specific investment classes, including alternatives like derivatives.
- Greater potential for loss due to use of leverage.
- More limited liquidity since they cannot be redeemed by the fund itself. In addition, trading in a closed-end fund may be more limited than it is for more traditional funds.
- Must be purchased through a broker, since they don’t make a market in their own shares.
Closed-End Funds Are Not For the Faint of Heart
Closed-end fund investing requires a higher risk tolerance than traditional mutual funds and ETFs. They’re best suited to those who are willing to add additional risk to their portfolios but done with only a minority position in an otherwise well-balanced portfolio.
The potential rewards are greater than they are with other fund types, but so are the risks. In the case of leveraged funds, it would be the equivalent of investing your personal account on margin. If you are uncomfortable doing that, you probably won’t want to invest in a leveraged closed-end fund.
Make sure you’re thoroughly acquainted with the closed-end fund you plan to buy and purchase it at a discount. Don’t ignore the fundamental reality that the fund needs to have a proven track record of stable returns. That’s a requirement for any type of fund you might be investing in, but even more so for a closed-end fund.
Written by Kevin Mercadante.
View the original article at here.