Closed-End Funds: An Investment Company

The Investment Company Act of 1940 established the framework for today's "funds." Closed-End Funds (CEF's) are one of the four main investment company types commonly operating, the other three being the Mutual Fund, the Exchange Traded Fund (ETF), and the Unit Investment Trust (UIT).

Closed-End funds are professionally managed investment companies that where investment advisors managed pooled capital. If this already is sounding a lot like a Mutual Fund, you wouldn't be mistaken. The CEF has some key distinguishing elements that we'll focus on, but, in essence, it is still a pooled investment company that must abide by the regulations that also govern ETF's and Mutual Funds.

Exchange Traded

Net Asset Value (NAV) Separate from Market Price

Typically Trade at Discount or Premium to Asset Value

Capital is Fixed- Portfolio Changes only at Management Discretion

Exchange Traded

Just like ETF's, Closed-End funds are bought and sold on an exchange. This allows investors to trade them intraday, potentially using different types of market orders to manage the expected sale price. This also means that the "minimum investment" is the price of a share of the CEF, which is quoted to the investor just like any stock. For example, the Royce Value Trust CEF (Ticker: RVT) is trading at $14.48 a share at the time of publishing.

This is a marked difference from the Mutual Fund, which is redeemable at the end of the day from the fund itself at the Net Asset Value. CEF investors receive the market price of the fund on the exchange instead. Mutual Funds also require a minimum investment amount typically. The fact that CEF's are exchange traded helps them avoid this issue for the fund investor.

Mutual Fund investors will also be familiar with the "Load" or the commission cost to buy or sell certain funds. Whereas Mutual Funds can carry a maximum of an 8.5% load according to FINRA (not that many charge much more than 6.5%), the exchange traded nature of a CEF helps investors avoid loads altogether. The CEF investor pays the same commission as their broker charges for a stock trade. Scottrade is charging $6.95 for an online trade these days, and there are others that charge even less, if anything at all.

Net Asset Value (NAV) vs. Market Price

Net Asset Value (NAV) of a fund company is the current value of all investments and cash, net of any debt and leverage cost the fund has outstanding. Mutual Fund investors receive fund shares at NAV when they buy or sell their investment- e.g., if you give a mutual fund $3,000, you will receive $3,000 worth of shares at the NAV.

Closed-End funds are traded at their market price. Market prices are often related to NAV, but they are rarely identical. Since CEF shares are traded on an exchange, they're subject to the same supply and demand forces as any equity investment.

Discounts & Premiums

Since there is a difference between the market price of a Closed-End fund and its Net Asset Value (NAV), this allows investors to purchase and sell CEF's at discounts and premiums to its intrinsic value. According to the Institute of Business & Finance, Closed-End funds have historically traded at a 4% discount to their NAV. The precise cause of this phenomenon is not known, though many theories exist. Since this is an introduction to Closed-End funds, I won't weigh in on this controversial topic. It's adequate to say that CEF's tend to trade at a slight discount to their NAV.

A common strategy used by CEF experts is to analyze Closed-End funds for discount to Net Asset Value on the market, purchasing investments at optimal discounts and waiting to sell until the relative discount has disappeared. There are many tools, metrics, and resources for utilizing this strategy- notably, the Z-Score of a CEF which measures current discount versus historical discount of a fund. Funds that sell at a premium to their NAV are obviously a risky buy, since they are patently over-valued relative to their intrinsic value. Nonetheless, we do not advise using the Discount & Premium features of a fund as the sole criterion for investing in a given CEF.

4
Average CEF Discount %
409
CEF's Currently at a Discount
106
CEF's Currently at a Premium

Fixed Investment Strategy

Our favorite feature of the Closed-End fund is that unlike Mutual Funds and ETF's, CEF's can stay invested in their investment program regardless of supply and demand for their fund on the market. This is because Mutual Funds that are accepting new investors must take new capital and invest it according to their investing program. Since investors tend to become interested in funds because of their recent performance, fund managers of Mutual Funds end up having to buy at sub-optimal times.

When the market, or the fund specifically, is down, investors tend to take their money out of the fund. When they do this, managers must meet those redemptions by taking money out of their investing program in the long run. This can hurt investors who stick with a fund for long periods, and it can hurt the ability of fund managers to plan for very long periods.

Closed-End funds start out with an initial capital pool and sell shares of that pool on the market. Their capital pool is not affected by investors of the fund, since investors transact with each other only via the market. This allows managers to utilize different strategies such as investing in less liquid securities and using leverage to invest. It also allows them to stick to their investment programs when times get tough or use strategies that are out of step with the broader market which might be more profitable in the long run. This feature of Closed-End funds tends to favor the long-term investor. Our readers will notice we here at Investment Annuity share this alignment with the long-term investor.

Therefor, knowing the investment theory and strategy of your CEF's management is critically important. They may be looking much further ahead than you'd like if you're looking for more rapid growth. They may be focused on deeper value investments, or they may be investing in much lower average quality in terms of Fixed Income.

218
$ Billion in Assets for the CEF Sector
627
CEF's on the Market
400
Fixed Income CEF's
214
Equity Focused CEF's
31
Global Equity CEF's
23
Emerging Market CEF's

Major Closed-End Fund Families

Conclusion

Closed-End funds offer a distinct set of benefits that's worth investigating for investors. Many of them are Fixed Income focused, but there are opportunities in every sector for CEF investing. Given that the CEF structure particularly benefits management of illiquid assets, sectors where securities are less liquid may be a good place to seek CEF opportunities, such as High Yield Bond and Municipal Bond funds. We hope to add more to the Closed-End fund discussion in time, but hopefully we've given fund investors a place to start in investigating the CEF landscape.

Thanks for joining us in our discussion of the Closed-End Fund industry. This is just a first step in discussing CEF's- we hope to write about individual sectors at more length in the future. We'd love recommendations for future Closed End Fund conversation topics, as well as any other comments and questions.

All information from this article from the Closed End Fund Association (CEFA) & the Institute of Business & Finance (I.B.F.).

Meet the Author & Portfolio Manager

Victor Schramm is a Certified Fund Specialist (CFS®), with expertise in Mutual Funds & Variable Annuity Separate Accounts. He focuses on long term investing geared toward our annuity clients as a Fee Only Investment Advisor. He lives in Portland, OR.

Victor Schramm, CFS®Analyst & Portfolio Manager

Disclaimer:

This information is solely a representation of publicly available facts intended for educational use only. This is not a solicitation to buy or sell any public or private Security, in any city named in the article or elsewhere. No information provided here about Closed-End Funds (such as Premium & Discount analysis) is to be used as a market timing tool for buying or selling any security. Closed End Funds are very complex investments that require a high degree of due diligence- this article is not investment diligence or investment advice in any form.

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