Christopher Raby, The Daily Record Newswire
Investors today have a wide array of products available to meet their investment needs. One of the most vastly under-utilized products is closed-end mutual funds. Despite the continuously growing popularity of open-ended funds and ETFs, closed-end funds remain beneath the radar of most investors. Closed-end funds are quite similar to their larger open-ended counterparts, with a few notable differences.
Closed-end funds begin their lives with an initial public offering, much like a typical common stock, where shares of the fund are issued. Once established, this share amount typically remains the same during the life of the fund. However, share repurchases, rights offerings and other transactions can alter this number.
The shares of a closed-end fund are traded on an organized exchange, such as the NYSE or the AMEX, and can be bought and sold at any point during the trading day. Also, because they are exchange traded, it is possible to engage in short sale and margin transactions. Open-end funds are created in a similar manner; however, their shares differ continuously because shares are created and redeemed when investors seek to enter or exit the fund.
The price of an open-end fund is calculated at the end of the trading day and is determined by taking the total market value of the portfolio and dividing it by the current number of shares issued (NAV). The price of a closed-end fund is determined solely by the supply and demand in the markets. Because of this, a situation arises where the fund will often trade at a price different than that of the underlying NAV. When a fund is trading at a value different than its underlying NAV, it is said to be trading at a premium (above NAV) or a discount (below NAV).
The exact cause of the existence of discounts/premiums has been tested in both academic and professional fields. Historical performance, fund manager reputation, expense ratios and investor sentiment are four reasons often given as explanation in academic studies. Market-based hypotheses include the differing fee structures and lack of incentive for brokers to recommend the funds to clients. However, this much-debated topic is still largely up in the air.
The fee structure of closed-end funds also differs from that of open-ended funds. Open-end funds typically charge a 12b-1 fee to cover the costs of share distribution as well as various advertising-related costs. Since closed-end funds do not have share redemptions, they are legally forbidden from charging 12b-1 fees. Additionally, open-end funds often charge sales loads associated with the purchase or sale (or both) of shares.
Closed-end funds have no such charge; the only associated costs are brokerage commissions similar to the purchase and sale of an individual stock. Lastly, conflicting evidence exists as to a difference in management fees, but it largely appears that fees are similar across both types of funds.
The last major point to note is that many closed-end funds employ leverage to boost returns. Because open-end funds must often buy and sell shares of the securities they hold based on investor purchase and redemptions, it is impractical for open-end funds to use any significant amount of leverage. Also, the use of leverage in municipal closed-end funds is especially unique since it is difficult for individual investors to buy individual municipal securities on margin in personal accounts.
Closed-end funds greatly trail the popularity of open-end funds, regardless of many significant advantages. In fact, a recent Blackrock publication noted the long-term outperformance of closed-end funds over similar open-end funds. An investment in a closed-end fund is worth considering for investors large and small. Nevertheless, the closed-end fund industry largely remains a mystery to the every day investor.
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Christopher Raby is a senior taxable fixed manager/fixed income analyst for 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.
