Close-End Funds: A Steady Income Vehicle

Every now and then you hear analyst and investors talk about Close-End Funds. So what are these funds ? What do they do ? Who manages them ? Who can invest in them ? Why would someone invest in them ? Let us find out.

What are Close-End Funds
Close-End funds are usually sponsored by a fund management company, which will control how the money pooled-in by the investors will be invested. Fund managers create a portfolio for the fund depending on the type of fund. Some funds invest in stocks, others in bonds, others in emerging market, and some in very specific things. Investors choose to place their assets in closed-end funds in the hope that the fund managers will use their management skills and deliver better returns.

The fund management company will issue a fixed number of shares to the investors in form of an IPO. These shares are given to the investors based on their initial investment. New shares are rarely issued after the fund is launched. These shares cannot be redeemable for cash or securities until the fund liquidates. New investors can acquire shares in a close-end fund which trades as a stock by buying shares in the secondary market from a broker, market maker or other investor.

Since shares are bought and sold on the open market after the IPO, investor activity has no impact on the fund manager’s decisions. This turns out to be advantageous for the fund and fund managers investing in small-cap stocks, emerging markets, high yield bonds and other less liquid securities. However each investor pays a commission to cover the cost of personal trading activity of buying and selling the fund.

Closed-end funds are typically traded on the major global stock exchanges.

Pricing Of Close-End Fund Shares
The price of a share in a closed-end fund is determined partly by the value of the investments in the fund, and partly by the premium or discount placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value (NAV). For closed-end funds the trading price may be higher or lower than NAV. The actual trading price is set by supply and demand in the marketplace.

If the trading price is higher than the NAV, the fund is said to be trading at a premium. If the trading price is lower than the NAV, the fund is said to be trading at a discount. (eg. Morgan Stanley Eastern Europe Fund (RNE) on the NYSE was trading at a premium of 39% in May of 2006 and at a discount of 6% in October of 2006).

When closed-end funds trade at a significant discount, the fund manager may make an effort to close the gap between the NAV and the trading price by offering to repurchase shares or by issuing reports about the fund to win investor confidence and generate interest in the fund.

Note On Discounts and Premiums
If the close-end fund is trading at a discount, ideally a savvy investor could buy up all the shares of the fund at the discounted price and force the fund manager to cash out at a higher market price. However in reality, liquidity concerns make it impossible to trade, since there are few shares available in the market. At discount prices the investment sounds like quick money maker. However the fund may not liquidate in the right timeframe and investors may be forced to sell at an even worse discount, or the investments in the fund may lose value.

Similarly at times, close-end funds trade at a high premium to NAV. Why would investors pay twice or even thrie the NAV ? One theory is that if the fund has a strong track record of performance, investors may speculate that the outperformance is due to good investment choices by the fund managers and that the fund managers will continue to make good choices in the future.

Raising Capital

Close-end funds can raise additional investment capital by issuing auction rate securities, preferred shares, long-term debt, and reverse-repurchase agreements.

Example Explaining Close-End Funds
Let us say Safe Fund Management company offers a close-end fund to its investors with IPO price of $10/share for its 10 million shares. $100 million will be raised once all the shares have been bought out, which will then be used by Safe Fund Management fund managers to invest. Once the fund is operational, the fund’s 10 million shares will begin to trade on a secondary market. Any investor who wishes to buy or sell fund shares at that point will have to do so on the secondary market. Investors will find the close-end fund shares generally trading above or below the NAV (in this case $10). The shares may trade for $9 or $11. In the former case, the fund would be said to be trading at a 10% discount to NAV. In the latter case, the fund would be said to be trading at a 10% premium to NAV. In either case, investors can expect a steady stream of income.

Advantage of Close-end Funds

  • Low fees due to no expense of creating and redeeming shares.
  • At times available at discount prices.
  • No need to worry about market fluctuations to maintain their performance record.
  • Investors sell to another investors, not forcing fund manager to change the portfolio.
  • Obey rules such as filing reports with the listing authority and holding annual stockholder meetings to help investors voice their opinion.

Why Closed-End Funds Aren’t More Popular
There are less than 1,000 closed-end funds in the marketplace. While closed-end funds are relatively few in number, they do still account for billions of dollars worth of investable assets. Their relative lack of popularity can be explained by the fact that they are fairly complex investment vehicles that tend to be less liquid and more volatile than open-ended funds. For these reasons, closed-end funds have historically been, and will likely remain, a tool used primarily by relatively sophisticated investors.

Conclusion: Fixed-income investors are often attracted to closed-end funds because many of the funds are designed to provide a steady stream of income, usually on a monthly or quarterly basis as opposed to the biannual payments provided by individual bonds.

Investors put their money into closed-end funds for solid returns on their investments through the traditional means of capital gains through price appreciation and dividend payments. The wide variety of closed-end funds on offer and the fact that they are all actively managed make closed-end funds an investment worth considering.

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(Source: Wikipedia)

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