Closed-End Funds

What is a Closed-End Fund?

Closed-end funds are related to open-end funds in organizational structure and are the original investment company. They offer investors several significant advantages over open-end or mutual funds. To understand this, keep in mind the meaning of the term net asset value (NAV). The NAV of any fund is based on the sum of the market values of all the fundís security positions, plus its cash and minus its liabilities:

Limited number of shares. CEFs have a limited number of shares because of their fixed capitalization. Open-end funds are constantly redeeming and issuing new shares.

Trading. The number of shares a CEF has is limited. CEFs and ETFs trade on a stock exchange while open-end funds do not. Open-end funds continuously offer shares to investors at NAV plus any front-end load or sales charges. They can redeem investor shares at NAV, net of redemption charges or back-end load.

Because they are not tied to NAV, the price of a CEF trades above or below its net asset value. This results in a premium (above NAV) or a discount (below NAV) allowing the CEF investor to buy and sell at known prices using limit orders, a major advantage.

Lower expenses. CEFs usually have lower expense ratios in part because they do not have the extra fees that open-end funds may levy in order to pay for marketing the fund.

Inefficient market. Information about CEFs is not always available, often creating price inefficiency in a relatively efficient marketplace. This allows sophisticated investors to garner above average long-term results.

No inopportune cash flows. CEF portfolio managers do not need to worry about ill-timed redemptions. When investors in open-end funds want to add money to those funds whose NAV is rising and withdraw it when it is performing poorly, they may force the open-end fund manager to buy when the value of the fund is rising or to sell when the value of a security is falling. This is what Investing 101 teaches us NOT to do and is one of the primary reasons why we think CEFs often outperform their open-end counterparts.

Higher volatility. CEFs tend to be more volatile than open-end funds. While the NAV volatility should be the same for both fund types, the price volatility of a CEF tends to be higher because of its market price and the fluctuation of the discount/premiums. This allows investors to buy or sell the fundís shares at better prices.

Leverage. Buying a fund at a discount gives the buyer leverage free of charge since it can amplify profits. We call buying a fund with a NAV of $10 at a discount of 10% ďbuying 90 cent dollarsĒ. The leverage works so that investors can earn income and appreciation on a full dollarís worth of assets, for an investment of 90 cents.

A CEF, which borrows money, has the ability to enhance the fundís yield. The additional yield comes at the expense of higher volatility. The leveraged fund should outperform the unlevered fund in a bull market, though it may under perform in a bear market. Few closed-end funds actually borrow money.

Another kind of leverage, particularly in the tax-free variety of closed-end funds such as those issued by a firm like Nuveen, are leveraged through the issuance of preferred shares, commonly 30 or 40 per cent of the fundís total capital.

Liquidity. Some CEFs are small in size, and their shares do not trade in large volumes. This can be a problem for investors, but we overcome it by being patient and buying when others are selling and selling when others are buying. Utilizing limit orders lets you wait for the shares to come to you.

Prospectus. Unlike mutual funds, CEFs only have to issue a prospectus before they go public, like other publicly traded companies.

ETFs (exchange traded funds): are baskets of index shares, which trade at or near net asset value and are similar in structure to CEFs. Although we havenít been using ETFs in our portfolios, we are considering them, as they are a way to enter some markets not covered by CEFs.

The Investment Opportunity

Today there are more than 970 closed-end (CEFs) and exchange traded funds (ETFs) worldwide, mostly trading on the New York Stock Exchange and representing every segment of the markets of the world.

Closed-end equity funds in the US include blue chip investors, small-capitalized growth funds and specialty funds such as those in healthcare, energy, real estate and utilities. Corporate bond funds, including multi-sector funds and convertible bond funds, are the largest sector.

The closed-end fund structure for global investing, our specialty, is particularly well suited for country funds in the less liquid emerging markets. Some open-end funds invest in these smaller markets, but we think investors who buy mutual funds in the less developed countries take too much risk in these largely illiquid markets.

Investors can profit two ways from investing in a closed-end fund. First, by identifying a fund with the potential to increase in value, a profit can be made by a rising net asset value. As this value grows and is noticed in the marketplace, there is a tendency for the discount to narrow, providing higher share prices. Investors must realize they can make a profit in the fund even if the discount doesnít narrow.

Some closed-end funds are excessively concerned with the discount. Many CEFs have successfully reduced their discount and enhanced performance by a combination of share repurchases and/or periodic tender offers at or near NAV.

For More Info - see: The Closed-end Fund Association or Site-By-Siteís CEF


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