What are the characteristics of closed-end funds (CEFs) and how to identify attractive candidates to earn a profit with closed-end fund investing
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What Are Closed-End Funds
A closed-end fund (“CEF”) is a type of mutual fund where investors pool their money and a professional money management team oversees the portfolio by selecting the underlying stocks, bonds, and other securities. A closed-end fund is a public, indirect pooled investment vehicle. You can learn more about the different types of investment vehicles in this guide.
Most investors are familiar with open-end mutual funds which are found in many employer-sponsored defined contribution plans such as 401(k) plans in the U.S.
Differences Between Open-End Mutual Funds and Closed-end Funds
There are some key differences between an open-end mutual fund and a closed-end fund. The first major difference is open-end mutual funds only trade at the end of the market day. Whereas, closed-end funds trade on a stock exchange throughout the trading day in a similar manner as exchange-traded funds (i.e. ETFs) or individual stocks.
A second key difference is closed-end funds have a fixed number of common shares outstanding while an open-end mutual fund issues or redeems new shares at the end of the market trading day. As investors seek to invest more money into an open-end mutual fund, the fund sponsor will create new shares to meet the demand. Likewise, as investors seek to exit the open-end mutual funds, the fund sponsor redeems shares.
With a closed-end fund, if investors want to buy into the fund, they usually have to purchase shares in the secondary market through their brokerage account, just like they would for an individual stock or ETF. Demand to buy or sell shares of closed-end funds leads to price fluctuations in those shares.
The exception to this practice of buying closed-end fund shares in the secondary market is when a new closed-end fund is launched or when an existing closed-end fund wants to raise additional money to invest. In those cases, the closed-end sponsor will offer shares to investors through an initial public offering or a secondary offering. Individuals can purchase those newly issued shares through their brokerage account.
Open-End Mutual Funds Versus Closed-End Funds
- Trade throughout the day
- Fixed number of common shares
- Market price of shares can differ from the net asset value
- Shares bought in the secondary market
- Shares can often be bought at a discount to the NAV
- Most use leverage
- Expense ratios are high
Open-End Mutual Funds
- Trade at the end of the day
- Unlimited number of shares
- Market price equals the net asset value
- Shares bought from fund sponsor
- Most don’t use leverage
- Expense ratios are lower than closed end funds
What is Net Asset Value?
Both open-end and closed-end mutual funds calculate the per-share net asset value for the fund on a daily basis. The net asset value or NAV is calculated by taking the value of the fund’s assets, including cash, subtracting the liabilities or debts the fund might have, and dividing by the number of shares outstanding.
Investors in open-end mutual funds exit and enter the fund at a price that equals the net asset value. Because closed-end fund investors buy and sell shares on an exchange, the price they pay or receive might be more or less than the net asset value.
Closed-End Fund Discounts and Premiums
When a closed-end fund’s price is higher than its net asset value it is selling at a premium. When the price of a closed-end fund is lower than its net asset value, it is selling at a discount.
One of the attractive features of investing in closed-end funds is the ability to purchase the fund at a discount to the net asset value. For example, when an investor buys a CEF at a 10% discount to the net asset value, that means the investor pays 90 cents for every dollar worth of assets.
Over 60% of closed-end funds in the U.S. are bond funds that have an objective of generating income for investors. In order to increase their income distributions, over 70% of U.S. closed-end funds use leverage. That means the funds borrow money and invest the proceeds in additional assets. If the newly purchased assets earn more than the cost of the debt, then the closed-end fund is able to generate additional income that can be distributed to shareholders.
Sources of leverage for closed-end funds include borrowing money from banks or the fund can borrow from investors by issuing its own debt. Some closed-end funds issue preferred stock that requires the CEF to pay dividends to preferred stockholders before making dividend distributions to investors in the closed-end fund’s common shares.
There are two types of leverage calculations for closed-end funds. Structural leverage represents the amount borrowed in debt and preferred stock as a percentage of the fund’s assets. Effective leverage includes structured leverage plus any leverage created by the fund’s investment in underlying securities that are levered.
Closed-end funds will generally keep leverage between 20% to 40% of the value of its assets. This leverage can lead to higher returns for investors, but it also makes losses more pronounced in down markets. Prudent investors focus on closed-end funds where the leverage is 35% or less.
Closed-end funds are more volatile than open-end mutual funds that invest in similar assets because CEFs use leverage and the price fluctuates around the NAV.
Closed-end funds are more volatile than open-end mutual funds that invest in similar assets because CEFs use leverage and the share price can fluctuate around the net asset value by selling at a discount or premium.
Closed-End Fund Expenses
Similar to open-end mutual funds, closed-end fund sponsors also charge a management fee to oversee the assets. The expense ratios for closed-end funds are higher than open-end mutual funds because closed-end funds are smaller in size, and they don’t have the ability to attract more assets into the fund without going through the expense of conducting a secondary offering to issue more shares. This contrasts with an open-end mutual fund that can attract large inflows into the fund if it is successful.
In addition to the management fee and other administrative expenses, closed-end funds also incur interest expense related to the leverage used.
How To Analyze A Closed-End Fund
Investors in closed-end funds need to understand the fund’s strategy. Is it investing in stocks, bonds, or some other asset class? If the CEF invests in bonds, what type of bonds does it invest in? Does the fund hold riskier non-investment grade bonds or less risky municipal bonds. Before buying shares, closed-end fund investors should be able to explain in simple terms how the fund invests and what are the risks of the particular strategy.
Investors should also consider the fees charged by the CEF, recognizing higher expense ratios can lower the overall return. CEF fees can vary significantly by fund so it is generally best to focus on CEFs where the expense ratio excluding the interest expense is less than 1.5%.
Distribution Rate and Source
Since most closed-end funds focus on generating income, it is important to understand a fund’s distribution rate and source. Closed-end funds distribute cash to shareholders via dividends. There are three types of distributions:
- Income distributions: This represents income earned from the fund’s investments.
- Capital gains distributions: This represents realized gains from the fund manager selling investments at a profit.
- Return of capital distributions: This represents the CEF’s unrealized gains or the original capital from investors raised in the initial public offering or secondary offerings.
The most dependable source of return is an income distribution. Closed-end fund research sites such as CEF Connect calculate a distribution yield for each closed-end fund. The distribution yield is calculated by taking the most recent distribution, annualizing it and then dividing it by the CEF’s price. Many closed-end funds have income distributions of 8% or more. The use of leverage allows the CEF to maintain a higher distribution yield than open-end mutual funds.
Some closed-end funds have a managed distribution strategy. These funds seek to pay a consistent dividend each month or quarter. If there is insufficient income to make the dividend payment, the fund will make up the difference with a return of capital distribution.
Generally, it is preferable to invest in CEFs where the distribution is funded entirely from income. If the distribution is being partially funded by return of capital then it is important to analyze whether the net asset value is holding steady or increasing over time as opposed to shrinking. If the net asset value is growing or holding steady, then the return of capital is being funded by unrealized gains, which means the distribution is more stable.
If the CEF has return of capital distributions and the NAV is declining, then that is not a sustainable long-term situation because it means the CEF is returning capital that was paid in by investors. A CEF might choose to return investor capital in order to show a higher distribution yield.
The most attractive time to purchase a closed-end fund is when its discount is greater than normal. Investing in a closed-end fund that is selling at a premium is risky because it means the investors are paying more than the underlying assets are worth.
Most closed-end funds are owned by individual investors. During down markets, many of these investors want to sell their holdings. That causes CEF discounts to NAV to widen. Opportunistic investors can seek to purchase closed-end funds at discounts that are greater than average. Using a site like CEF Connect, investors can see a graph showing the discount over time to assess if the current discount is wider than average.
CEF Connect also calculates a Z-score for the discount. The Z-score is the current discount or premium minus the average discount or premium divided by the standard deviation. The standard deviation measures the volatility of the premium or discount over time. Z-scores allow investors a standardized way to compare one fund’s discount to another. A Z-score greater than -3, represents a CEF that is selling at a discount that is a significant departure from its average discount.
The Ideal CEF Purchase Candidate
In summary, the most attractive closed-end fund candidates are those:
- Where the investor understands the risk and reward of the investments the CEF owns.
- Where the fees are lower.
- Where the effective leverage as a percent of assets is 35% or less.
- Where the distribution is primarily funded by income.
- Where the discount to net asset value is greater than average.
Investors who identify CEFs that meet these criteria can benefit from collecting income while they wait for the discount to NAV to narrow to its average. At that point, the investor can sell the CEF and lock in the gain or continue to hold the CEF as long as it continues to sell at a discount. The CEF should be sold if it moves to a premium.
Podcast Episode 290: What Is A Closed-End Fund and How to Invest in Them
Why closed-end funds are an attractive investment vehicle, particularly during market panics. What are the unique characteristics of these funds and what are successful strategies for investing in them.
Topics covered include:
- How closed-end funds differ from open-end mutual funds and ETFs.
- Why most closed-end funds are bond funds and use leverage.
- Why closed-end funds can sell at large discounts and premiums.
- What are managed distribution programs.
- How to evaluate and select closed-end funds.
- What is the Income Factory approach to closed-end fund investing.
David Stein has produced and hosted the investing podcast Money For the Rest of US since 2014. He is the author of Money for the Rest of Us: 10 Questions to Master Successful Investing, which was published by McGraw-Hill. Previously, David was an institutional investment advisor and asset manager. He was a managing partner at Fund Evaluation Group, LLC, a $70 billion investment advisory firm. At FEG, David served as Chief Investment Strategist and Chief Portfolio Strategist.