- Closed-end funds are investment companies whose stock or ETF shares are traded on the open market.
- When shareholders buy or sell shares, capital does not flow into or out of the funds.
- CEFs can invest in illiquid securities and issue debt and/or preferred shares due to their steady asset base.
What exactly is a closed-end ETF?
One of three main types of investment firms is a closed-end fund, sometimes known as a closed-end investment company. Open-end funds (typically mutual funds) and unit investment trusts are the other two forms of investment businesses (UITs). ETFs are often formed as open-end funds, although they can also be structured as unit investment trusts (UITs).
A closed-end fund invests the money it raises in stocks, bonds, money market instruments, and/or other securities after its initial public offering.
Closed-end funds have a number of conventional and distinguishing characteristics:
- A closed-end fund, on the other hand, does not sell its shares on a continuous basis, but rather sells a set amount of shares at a time. The fund usually trades on a market after its initial public offering, such as the New York Stock Exchange or the NASDAQ Stock Market.
- The market determines the price of closed-end fund shares that trade on a secondary market after their original public offering, which may be higher or lower than the shares’ net asset value (NAV). A premium is paid for shares that sell at a higher price than the NAV, while a discount is paid for shares that sell at a lower price than the NAV.
- A closed-end fund is not obligated to purchase back its shares from investors if they want it. Closed-end fund shares, on the other hand, are rarely redeemable. Furthermore, unlike mutual funds, they are permitted to hold a higher percentage of illiquid securities in their investing portfolios. In general, a “illiquid” investment is one that cannot be sold within seven days at the estimated price used by the fund to determine NAV.
- Closed-end funds are regulated by the Securities and Exchange Commission (SEC). Furthermore, closed-end fund investment portfolios are often managed by independent organizations known as investment advisers who are likewise registered with the SEC.
- Monthly or quarterly payouts are customary for closed-end funds. These distributions can include interest income, dividends, or capital gains earned by the fund, as well as a return of principal/capital. The size of the fund’s assets is reduced when principal/capital is returned. When closed-end funds make distributions that involve a return of capital, they must issue a written notification, known as a 19(a) notice.
Closed-end funds come in a variety of shapes and sizes. Each investor may have distinct investment goals, techniques, and portfolios. They can also be vulnerable to a variety of risks, volatility, as well as fees and charges. Fees lower fund returns and are an essential aspect for investors to consider when purchasing stock.
Before buying fund shares, study all of the available information on the fund, including the prospectus and the most current shareholder report.
What’s the difference between an ETF and a closed-end mutual fund?
- You can create limit orders, short the shares, and buy on leverage with CEF and ETF shares, just like you can with stocks.
ETFs contain a redemption/creation function, which helps to guarantee that the share price stays close to the net asset value. As a result, the capital structure of an ETF is not complete. A feature like this does not exist in CEFs. Most ETFs are meant to replicate the performance of an index, whereas CEFs are actively managed. CEFs get their leverage via debt and preferred stock issues, as well as financial engineering. ETFs are not allowed to issue debt or preferred stock. ETFs are stronger than CEFs or open-end funds in protecting investors from capital gains.
Is an exchange-traded fund (ETF) a sort of closed-end fund?
While all investments entail some level of risk, closed-end funds carry a higher level of risk. Many people may want to invest in an exchange-traded fund (ETF). ETFs, like closed-end funds, trade throughout the day, but they often track a market index, such as the S&P 500, which is a stock market index of significant U.S. corporations. As a result, ETF management fees are frequently lower any difference in fees is returned to investors.
Do ETFs have an open or closed end?
Closed-end funds are mutual funds that are not open to the public “The fund is “closed” in the sense that no new money flows into or out of it after it raises capital through an initial public offering (IPO). A closed-end fund’s portfolio is managed by an investment company, and its shares are actively traded on a stock exchange throughout the day.
Unlike ETFs and mutual funds, closed-end funds have a secondary market where outside investors can purchase and sell shares. A closed-end fund’s management does not issue or repurchase shares.
“The supply of shares is often fixed at that moment, which is why it is dubbed a “closed-end” fund,” says Jon Ekoniak, managing partner at Bordeaux Wealth Advisors in Menlo Park, Calif., after a closed-end fund’s IPO.
Open-ended funds include mutual funds and exchange-traded funds (ETFs). They’re “When outside investors buy and sell shares, the fund’s management issues and repurchases the shares, rather than other outside investors selling and buying them.
The majority of closed-end funds are traded on the New York Stock Exchange (NYSE) or the Nasdaq, where they are actively traded until the fund achieves its goal, liquidates, and returns capital to its investors.
Closed-End Funds and Liquidity
The number of shares that an open-ended fund can issue is unlimited, and capital flows freely into and out of the fund as new shares are issued and repurchased. Managers of mutual funds and exchange-traded funds (ETFs) will continue to sell shares as long as there is a market for them.
As a result, mutual funds and exchange-traded funds (ETFs) offer more liquidity than closed-end funds. The fund’s management is continually looking for buyers for your shares, so you can earn cash for your investment quickly. However, open-ended funds must keep cash on hand in order to buy back investor shares if necessary, preventing them from fully investing all of their assets at any particular time.
Closed-end funds, on the other hand, can invest nearly every dollar because they aren’t compelled to repurchase shares on a regular basis. They can also invest in less liquid asset categories and use leverage as a result of this. Leverage, in particular, is a dangerous investment strategy since it has the potential to magnify both positive and negative outcomes. Closed-end funds, on the other hand, have less liquidity because your ability to sell is constrained by market demand.
Closed-End Funds, Trading Price and NAV
The entire assets of an investment fund minus its debts are divided by the number of outstanding shares to arrive at the net asset value (NAV). To put it another way, it’s the amount of assets that each fund share is entitled to if the fund were to liquidate.
Because mutual fund shares are not directly traded on an exchange, the NAV of a mutual fund tends to be the same as its share price. To keep the NAV balanced, management issues and repurchases shares every day.
Share prices and NAVs do not have to match for instruments that actively trade on a stock market, such as ETFs and closed-end funds. The value of the fund’s assets may be higheror lowerthan the price of the fund’s shares. In practice, this means you may be able to buy closed-end fund shares for a premium or discount.
“Trading 5 percent to 10% below net asset value is not uncommon, according to Todd Jones, chief investment officer at Gratus Capital, an Atlanta-based investment advising business. This discount could allow fixed income investors who are dissatisfied with the current low-rate environment to increase their yield effectively.
This disconnect between NAV and trading price offers closed-end fund investors a once-in-a-lifetime chance. They gain access to two revenue streams. “First, if the holdings’ NAV grows; and second, if the discount narrows or the premium widens,” says Robert R. Johnson, a finance professor at Creighton University’s Heider College of Business.
Is a closed-end fund a bad investment?
Investors in traditional (no load) open-end mutual funds and exchange-traded funds can generally enter and exit the funds at or near their net asset values; however, investors in closed-end funds will often find that the market value of their shares trades at discounts (or sometimes premiums) to their net asset values. Whether the closed-end fund trades at a premium or discount to its net asset value (and by how much) is largely determined by whether it makes good or terrible economic sense.
There are two strong reasons for a closed-end fund to exist: (1) to invest in illiquid underlying investments like senior loans that may yield an illiquidity premium, and (2) to deploy leverage in asset classes like municipal bonds that may not be leverageable to retail investors otherwise.
When a closed-end fund’s management utilize their closed-end structures to collect hefty fees from their captive investors, it’s a terrible thing. Many closed-end funds exist solely to rake in large fees from investors, such as initial offering fees and exorbitant maintenance costs. As a result, the majority of closed-end funds trade at significant discounts to their net asset values.
Closed-end funds can benefit savvy investors if they invest cautiously and prudently in those closed-end funds that trade at discounts from their net asset values that more than cover the fund’s management expenses. Patience, discipline, and a thorough understanding of discount drivers are required for a long-term program of effective closed-end fund investing. Investors should stick with ultra-low fee ETFs and open-end funds if none of these characteristics are present.
When a closed-end fund shuts, what happens?
A closed-end fund is a form of mutual fund that raises cash for its initial investments by selling a limited number of shares in a single initial public offering (IPO). Its shares can then be purchased and sold on a stock exchange, but no new shares or money will be produced or flow into the fund.
An open-ended fund, such as most mutual funds and exchange-traded funds (ETFs), on the other hand, takes fresh investment capital on a continuous basis. On demand, it issues new shares and buys back its existing shares.
Closed-end funds include many municipal bond funds and some global investment funds.
What are the benefits of investing in a closed-end fund?
Expense Ratios that are lower. Closed-end funds, unlike open-end funds, do not have continuing costs associated with distributing, issuing, and redeeming shares because they have a set number of shares. Closed-end funds often have lower expense ratios than other funds with identical investing strategies as a result of this.
Closed-end funds have a number of drawbacks.
Active management, on the other hand, usually entails a higher level of fees and expenses deducted from the fund. A closed-end fund must climb a steeper hill to match the returns of index funds, which simply reflect the performance of market indexes and do not require active management, due to the higher costs. When buying and selling closed-end shares, shareholders must pay higher fees as well as brokerage costs. Closed-end mutual funds are thus at a disadvantage against open-end “no load” mutual funds, which do not charge sales commissions up front.
What are the main benefits of ETFs versus closed-end funds?
Investors should be aware of the key differences between closed-end funds (CEFs) and exchange-traded funds (ETFs) (ETFs). Each has its own set of benefits and drawbacks. This knowledge can help you make better investment decisions. Let’s concentrate on the most important elements.
Fees
In comparison to CEFs, ETFs have lower expense ratios. ETFs are less expensive to manage than actively managed portfolios since they are indexed portfolios. Due to their low portfolio turnover, ETFs frequently have lower internal trading costs than actively managed funds. The cost reductions from ETFs can be substantial, particularly for long-term investors. Brokerage commissions are frequently charged when investing in ETFs and CEFs. The fund prospectus contains information on specific fees, charges, and expenditures.
Fund Transparency and NAV
The transparency of ETF holdings is great because fund components are connected to an index. By consulting the index provider or fund sponsor, investors can quickly discover the underlying stocks, bonds, or commodities of a fund. Because CEFs’ portfolios are actively maintained, they offer less transparency, however holdings can be discovered by looking at quarterly or semiannual fund reports.
ETFs are typically traded at or around their net asset value (NAV). ETFs seldom trade at a significant premium or discount to their NAV, although it does happen. Historically, institutions have viewed this as a chance for arbitrage by forming or disbanding creation units. The NAV of the underlying index or basket of securities is closely linked to the ETF share price as a result of this procedure.
CEFs, on the other hand, are more likely to trade at a premium or discount to their net asset value (NAV). A premium indicates that there is more demand (more buyers than sellers) for a fund’s shares, whilst a discount indicates that there is less demand (more sellers than buyers). The NAV is determined by subtracting a fund’s liabilities from its total assets and dividing the result by the number of outstanding shares.
Style Drift and Leverage
In comparison to index ETFs, active CEFs are more prone to style drift. Actively managed portfolios are prone to style drift, as money managers occasionally stray from their original investment approach. ETFs, on the other hand, are mostly immune to style drift because a portfolio manager’s ability to handpick stocks beyond the scope of an index is constrained.
Many CEFs are leveraged, causing NAV volatility to be magnified. Leverage can be useful if portfolio managers make the right decisions. Poor investing decisions in a leveraged portfolio, on the other hand, can be disastrous. Currently, ETFs do not use leverage in their investment approach, but this may change in the future.
Both ETFs and CEFs must provide dividends and capital gains to owners on an annual basis. Index rebalancing, diversification rules, and other variables might trigger these distributions, which are normally done at the end of each year. Additionally, any time you sell your fund, you may face tax repercussions.
ETFs are known for having minimal portfolio turnover, which benefits investors by reducing the risk of tax gain distributions. Actively managed portfolios, on the other hand, have a greater turnover rate, resulting in more frequent tax distributions.
(1) ETFs and closed-end funds may not be offered as an investment choice for employer-sponsored retirement plans. ETFs and closed-end funds may be available as part of a self-directed retirement plan’s investing options.
(2) Merrill Lynch’s HOLDRs are an exception, as they can only be acquired and sold in 100-share increments.
What does a closed-end fund look like?
Alternative investments such as futures, swaps, and foreign currency are more likely to be included in closed-end funds’ portfolios than open-end funds. Municipal bond funds are an example of closed-end funds. These funds invest in municipal and state government debt in order to reduce risk.
Distributions from closed-end funds might originate from a variety of sources. Dividends, realized capital gains, and interest from fixed-income assets held in the funds can all be sources of income. Every year, the fund company passes the tax burden on to owners by releasing a form 1099-DIV that breaks down dividends.