Closed-end Mutual Funds

A closed-end mutual fund also called a closed-end fund (CEF), is a fund that generates money by offering a specific amount of non-redeemable shares and then invests that cash in financial securities like stocks and bonds.

These mutual funds obtain a specific volume of financial resources from investors using an Initial Public Offering (IPO) and issue their shares on a share market. 

A fund manager manages this type of mutual fund; it sells like securities and is a publicly listed investment corporation.

Managers do not generate additional shares in CEFs to fulfill investor demands as they do in open-end funds.

Rather, the shares may only be acquired and traded in the open market, as was the initial concept of the mutual fund, which precedes open-end mutual funds but provides the same actively-managed pooled assets.

Such funds include several municipal bond funds and certain global investment funds. Adams Express Company, Witan Investment Trust, Scottish Mortgage Investment Trust, Tri-Continental Corporation, Gabelli Equity Trust, and others are instances of prominent closed-end funds.

Understanding Closed-End Mutual Funds

These funds appeared in 1893, well over 30 years before the initial mutual fund was established in the United States. 

There seem to be upwards of 500 closed-end funds, with performance and management backgrounds going back more than 50 years.

They are often listed on a renowned share market and can be purchased and traded there. The market decides the price per share, frequently distinct from the actual or net asset value (NAV) per share of the fund's investments. 

When the funds trade beyond the value, it is considered to be selling at a premium; when it trades underneath this value, it is described as selling at a discount.

A premium could be produced by the market's faith in the capacity of the financial advisors or the underlying assets to provide above-market returns. 

A discount may indicate prospective fees to be removed from the fund by the management, uncertainties from high levels of leverage, liquidity problems, or a lack of investor trust in the underlying assets.

An initial public offering is launched to produce funds for this kind of mutual fund. Those that invest resources in the mutual fund are given shares.

Following that, the stocks are offered on the secondary market and exchanged by investors following supply and demand.

As the name suggests, a closed-end mutual fund does not offer new shares or buy back existing ones.

These funds are known as closed-end businesses under US law, and they are among three SEC-recognized forms of investing firms, together with mutual funds and unit investment trusts.

Market Price of a Closed-End Mutual Fund

Closed-end fund market values are publicized and accessible through all recognized financial information sources. As a result, investors looking to purchase or sell a CEF can choose when and at what rate they want to complete the deal.

Consequently, the sale value of a particular fund is determined by supply and demand and may vary from the fund's NAV on any specific date. As a result, any closed-end fund's market value is expected to be higher or lower than its present NAV.

Several factors might cause this phenomenon. For example, if the investment is in great demand and has limited availability, the market rate will usually surpass the NAV. 

Conversely, when there is little need and an abundance of availability, the market rate is frequently lesser than the NAV.

Whether the market rate is above or below the NAV may depend on the idea that a mutual fund will perform well, much like shares.

Portfolios with securities likely to do positively in the coming years may attract a premium over NAV. In contrast, those with securities predicted to play badly may trade at a discounted value.

A CEF might not only operate at a discount to its NAV but also sell less than its IPO value. While evaluating the purchasing of a CEF during its first public offerings, investors would have availability to the offer document, which includes complete data about the fund's managers, plan, and threats.

Distinguishing characteristics of a Closed-End Mutual Fund

A closed-end fund typically offers a specific volume of securities at once rather than constantly offering its securities to the public. 

The fund often operates on a market like the New York Stock Exchange or the NASDAQ Stock Market following its first public offering.

Following their first market release, CEF assets operate in a secondary market. As a result, the pricing of the stocks is decided by the economy and could be higher or lower than their net asset value (NAV). 

Stocks are considered to be traded at a premium if they are bought for more than the NAV and at a discount if they are purchased for less than the NAV.

Generally speaking, a closed-end fund is not obliged to repurchase its assets from shareholders upon asking. In other words, assets of CEF typically cannot be redeemed. 

Additionally, compared to mutual funds, they are permitted to have a more significant proportion of illiquid assets in their trading portfolios. 

An investment is deemed "illiquid" if it cannot be sold within seven days at the estimated value the fund used to calculate NAV.

Closed-end funds are regulated by the SEC and are listed with the SEC. Additionally, the CEF's investment holdings are often overseen by independent organizations known as investment advisors who are also SEC-registered.

Payouts from CEFs are generally made on a quarterly or monthly schedule. The fund's revenue, such as interest, dividends, or capital profits, as well as a recovery of principal or capital, may be included in these payments. 

The fund's holdings decrease when the principal or capital is returned. Every time payments involve a return of capital, CEFs are obliged to provide a formal notice, known as a 19(a) notice.

The Pros & Cons

CEFs often have more significant holding periods than open-end funds. As a result, short-term declines have little impact on them. On the contrary, no venture is without danger. Closed-end funds come with their unique series of concerns. 

Let us explore these advantages and drawbacks:

Benefits of CEFs:

1. A discounted cost is one significant benefit that several CEFs provide. As a result, these funds may trade at a gain or a deficit to their net asset value, which is the total of all financial assets divided by the total amount of outstanding shares.
2. This fund benefits the management team because they are not required to stress obtaining money for investor repayments. In addition, when the fund begins operating, every one of the stocks is offered.
3. Investors who wish to sell their shares need to place a sell order, and the purchaser pays the revenues of the transaction, not the fund. As a result, fund managers now have greater freedom in selecting assets and trading choices.
4. Just like securities, CEFs are exchanged every day on stock markets. These are particularly liquid financial assets as a result. This makes it appealing for potential traders to be interested in buying such assets. 
5. This makes it possible to purchase and trade this asset with greater flexibility. Additionally, they also provide extra benefits. For example, compared to comparable capital market funds, there is a greater chance of generating a larger income yield.

Disadvantages of CEFs:

1. Traders should be wary of funds traded at a markup to their asset value. There is no assurance that a fund's holdings will keep improving in size, and shareholder excitement, which the premium symbolizes, can change abruptly. 
2. In almost all circumstances, a decline in valuation toward a zero premium will lead to a cost on the investment. Accordingly, mutual fund market analysts typically recommend that novice traders avoid funds selling at a premium. 

3. As a result, there is a good chance that no additional investments will enter the fund, and the premiums will finally vanish.

4. A CEFs quest to achieve the results of index funds, which replicate the results of market indices and do not demand effective management, is more difficult due to the hefty fees.

5. Investors who purchase and trade closed-end stocks incur additional fees and broker's costs. Because open-end mutual funds do not levy advance commission fees, closed-ends are at a handicap.

How are they different from Open-End funds?

Mutual funds are open-ended investment funds. The total amount of securities may offer unlimited. Open-end funds are not traded on a stock exchange. Instead, the firm initially offered its stock will buy back its stocks.

Since a CEF is publicly traded, it must follow specific laws, like submitting records with the listing authorities and having yearly shareholder meetings.

There is just one daily pricing for open-end funds. The funds are revalued depending on the number of shares purchased and traded at the close of each trading period. The shares' net asset value determines their cost.

Hence, investing $1000 in the fund implies owning shares with $1000 in underlying securities. However, purchasing a CEF and selling at a markup could require paying $1000 for investments valued at $900.

Compared to their open-ended counterparts, CEFs have a few monetary benefits. For example, CEFs avoid the costs of issuing and redeeming stocks, store fewer funds in their portfolios, and do not have to worry about economic uncertainty to preserve their "strong performance." 

If a share falls rapidly, the CEF could seize an opportunity, whereas open-ended funds may sell too soon.

Open-ended mutual funds generally provide significant liquidity as opposed to closed-ended funds, wherein liquidity is only accessible after the designated lock-in term or at fund maturation. This is a key distinction between the two types of mutual funds.

In addition, in the event of a financial crisis, traders may dump a certain share or group of shares in large numbers. 

When confronted with a flood of sell demands and the necessity to finance repayments, the management of an open-ended fund may be obliged to dispose of shares he would otherwise hold and retain shares he might prefer to sell owing to liquidity issues. 

As a result, it could grow overweight in stocks of lesser regarded value or declining firms with limited demand. However, because an investor withdrawing from a CEF should offer the shares on the market to some other investor, the managers are not required to dispose of any part of the underlying assets.

The CEFs value will almost certainly fall faster than the markets, harshly hitting all who dispose of shares during the crisis, yet it is more likely to rebound when and if the shares recover.

Researched and Authored by Raghav Dharmarajan

Reviewed & Edited by Ankit Sinha | LinkedIn

Free Resources:

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Multi-Asset Class
• Mutual Funds
• Myopic Behavior
• Naked Call
• Naked Credit Default Swaps