Closed-end funds are versions of mutual funds that issue a fixed number of shares through an initial public offering (IPO) to raise capital for their initial investments. The shares can then be bought and sold on the stock exchange just like stocks, but after the IPO, no new shares are created and no new money flows into the fund. Common examples are municipal bond funds and global investment funds.
Comparatively, open-ended funds like most mutual funds and exchange-traded funds (ETFs) take in a steady stream of new investment capital, along with issuing new shares and buying back their shares when they need to.
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Understanding Closed-End Funds
Similar to mutual funds, closed-end funds have a professional investment manager that oversees the portfolio and actively buys, sellins, and holds assets. And similar to stocks and ETFs, shares of closed-end funds fluctuate in price constantly.
Among the other many similarities between closed-end funds and open-end mutual funds, both make distributions of income and capital gains to their shareholders. They also both charge an annual expense ratio for management. Finally, companies offering closed-end funds must be registered with the Securities and Exchange Commission (SEC).
What Advantages Do Closed-end Funds Have?
Easily Traded Like Stocks
Closed-end funds are normally listed on major exchanges like the New York Stock Exchange, which gives their investors the benefit of intra-day liquidity.
Access To Unique Opportunities
The “closed” nature of the fund empowers the managers of the portfolio to buy into a broader opportunity set, which can even include less liquid investments that offer the potential of higher incomes and returns.
Increased Income Potential Using Leverage
Another notable advantage of CEFs is that they can borrow money to increase their investment positions to bolster the potential for higher income and capital appreciation.
What Are Some Examples Of Closed-end Funds?
Tax-exempt Municipal Bond Funds
These funds primarily invest in tax-exempt municipal bonds and sometimes use leverage to increase their income potential.
Taxable Fixed Income Funds
This type of fund invests in one or more fixed income sectors and may also use leverage to increase their earnings potential.
Closed-end equity funds invest in stocks and sometimes implement an option overwrite strategy to improve income potential.
How Are Closed-End Funds Different From Open-End Funds?
An open-end mutual fund can issue new shares whenever an investor wants to buy into the fund, and the fund can buy the shares back when they’re available on the market.
In contrast, closed-end funds issue shares only once. The only way to buy into the fund later is to find already existing shares on the exchanges.
Often, closed-end funds will use leverage to bolster the returns for shareholders. While there’s a stronger chance for higher returns when things go well, there are also higher potential risks when they don’t.
One thing to keep in mind about both closed-end and open-end funds is that they both come with fees. Closed-end funds are usually actively managed, so they charge relatively high fees when compared with index funds or ETFs.
Common Misconceptions Surrounding Closed-end Funds
CEFs can offer investors solid earnings potential. However, there are often some misconceptions surrounding them.
Misconception #1: CEFs are exchange-traded funds (ETFs)
While CEFs do share some traits with ETFs, there are still significant differences. Most notably, CEFs are actively managed, while ETFs are passively managed by tracking an index such as the NASDAQ or Dow Jones. Finally, unlike ETFs, a CEF can issue debt or preferred shares.
Misconception #2: A high percentage return of capital diminishes CEF returns
Return of capital is a complex tax concept to grasp. Essentially, CEFs can sometimes use return of capital to lower tax obligations for their investors. But keep in mind, this is only one aspect of many to consider when buying into a CEF. Due diligence and seeking tax professional advice is wise when assessing the viability of a particular CEF investment.
What are the risks associated with Closed-end Funds?
Like any investment product, closed-end funds come with a range of risks, which we’ll cover next.
Market Risk Of Capital Loss
Similar to open-end funds, closed-end funds are just as susceptible to market fluctuations and volatility. CEF values can drop due to the overall movements in the financial markets.
Risk Of Rising Interest Rates
Changes in interest rates can affect the income produced by a CEF. Funds with a portfolio holding a significant percentage of fixed income assets such as bonds can have more exposure to this type of risk when interest rates change.
CEFs are just as exposed to the various external risks as other exchange-traded investments, including liquidity risk on the secondary market, credit risk, concentration risk, and discount risk. If the CEF happens to include investments in foreign markets, it will have exposure to foreign market risks as well, which include currency, political, and economic risks.
What Should You Consider Before Investing In A Closed-end Fund?
What’s Your Investment Objective?
It’s important for investors to fully understand a closed-end fund’s main investment objective. This can be found in the CEF’s prospectus along with any shareholder reports. Understanding the primary investment objective will help you determine whether the CEF suits your overall investment goals and degree of risk tolerance.
What’s The Total Return?
To gain a solid understanding of the true historical performance of a CEF, it’s crucial to calculate the CEF’s total return. This calculation examines both the price return along with any distributions like realized capital gains and income. Other aspects to dig into include asset composition, risk level, duration, use of leverage, managed distributions, and covered call writing.
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Frequently Asked Questions:
A closed-end income fund is a type of investment company that raises capital through the sale of a limited number of shares. The fund invests in a diversified portfolio of income-generating securities, such as bonds or dividend-paying stocks, with the goal of providing regular income to shareholders. Unlike open-end funds, the number of shares in a closed-end fund is fixed and does not change in response to market demand, making their price subject to supply and demand dynamics.
Closed-end income funds create income by investments in a diverse portfolio of income-producing securities, such as bonds, dividend-paying equities, and real estate investment trusts (REITs).
The fund may also employ leverage to increase portfolio returns by borrowing money to invest.
The profits are subsequently dispersed to shareholders as dividends or interest payments.
The amount of income earned might fluctuate based on the portfolio’s holdings and market circumstances.
Before investing in closed-end income funds, investors should consider their personal financial situation, investment goals, and risk tolerance. It’s also important to understand the underlying portfolio and the risks involved, including the use of leverage and the fund’s exposure to interest rate risk. The fund’s historical performance, fees, and the experience and track record of the fund manager should also be considered. Finally, investors should keep in mind that the price of a closed-end fund can be influenced by supply and demand dynamics, which can result in the fund trading at a premium or discount to its net asset value.
President of Saint Investment Group
Nic is a two decade seasoned expert in investing and capital raising, specializing in Real Estate and debt markets. With Saint Investment Group, he leads large-scale distressed asset purchases and innovative syndications for investors.