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Money Management: Understanding closed-end mutual funds

George Kiriakos

Investors are often puzzled when they hear the term closed-end funds. While they are often familiar with traditional mutual funds (or open-end funds), their closed-end cousins are often viewed as too esoteric to be worthy of consideration. The following is intended to serve as a primer to the world of closed-end funds.

A closed-end fund is a form of investment vehicle that, much like their open-end brethren, invests in various securities such as stocks and bonds. The main differentiating factor between closed-end funds and traditional open-ended mutual funds is that the number of shares issued is typically finite. Thus, the term closed-end.

Similar to traditional companies, a closed-end fund typically raises capital through an initial public offering. However, once this initial funding is in place, the fund sponsor generally will not issue any more additional common shares.

Once established, the fund is then listed on a national exchange and may be bought or sold throughout the trading day, just like most other securities. Investors who want access to a closed-end fund after the initial public offering, must purchase those shares from a current shareholder in the open market, which leads to the other defining characteristic of closed-end funds — trading at a discount or premium to Net Asset Value.

Net Asset Value, or as it is more commonly known, NAV = (fund assets – fund liabilities) / # of shares outstanding. For open-end funds, the NAV per share typically equates to the market price.

As noted above, the market price of a closed-end fund may actually be higher (selling at a premium) or lower (selling at a discount) than the NAV. The main reason for this differential lies in the limited number of shares available and the age old laws of supply and demand as well as typical fundamental or subjective reasoning.

When demand for shares of a particular closed-end fund exceeds the supply, the market price of the fund shares is typically bid up to a level above the current NAV and the fund sells at a premium (think about trying to buy the hottest toy or tech gadget a day or two before Christmas).

Conversely, when sellers outnumber buyers, demand falls and the market value of the closed-end fund may drop below the current NAV. The key element is that the market price of the closed-end fund share is based not only on the fund manager’s ability to pick investments, but also on supply and demand.

Value oriented investors will typically try to take advantage of such dislocations and purchase shares trading at a discount with the intent of selling them at a future date when the market price is near or above the underlying NAV.

In addition to price movement, holders of closed-end funds will also typically receive current income in the form of dividends or interest as well as fund distributions. These payouts are akin to those received by holders of the more traditional open-end mutual funds and may occur monthly, quarterly or annually.

So with the basics out of the way, let’s have a look at some of the possible advantages that closed-end funds offer to investors.

• By purchasing shares of a closed-end fund you are in effect buying the skill of the fund’s manager.

• Unlike successful open-end funds, which tend to grow to the point that size becomes a burden on the fund manager, the ultimate size of a closed-end fund is finite.

• Without the pressure of having to manage daily inflows and outflows of cash, the closed-end fund manager may be able to take advantage of longer-term thinking and position their portfolio accordingly. As noted in “An Empirical Study of Closed-end Funds” (Qi & Alikakos April-June 2004) the efficiency of the closed-end structure leads closed-end funds to outperform their open-end counterparts.

• Closed-end funds are priced throughout the day and may be traded intra-day as opposed to their open-ended cousins, which typically trade once a day based solely on the closing price.

• Closed-end funds typically have lower operating costs than traditional mutual funds as there is minimal need to incur marketing and distribution costs. As a result, closed-end funds typically do not charge 12b-1 fees.

Investors should be aware that closed-end funds may employ leverage. Leverage may occur at a structural level by borrowing capital or through the issuance of preferred shares, or at the portfolio level (typically more opportunistic and achieved through the use of derivatives).

The use of leverage generally allows the fund manager to borrow at short-term rates and invest at longer-term rates capturing the benefit from the differential as an enhancement to return.

As noted in the June 2010 paper “Why Do Closed End Bond Funds Exist?” by Elton, Gruber, Blake & Shachar, while leverage may increase the volatility of a closed-end fund, the corresponding increase in overall return coupled with the low correlation with other assets in an investor’s overall portfolio will generally leave the investor better off. This may prove to be advantageous as we move through the slow growth, low return environment many pundits predict over the next few years.

George Kiriakos is a senior vice president at Karpus Investment Management, a local, independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.

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