Lessons from the Pros

Proactive Investor

Pooled Investments – Closed-end Funds

There are various types of pooled investments including: mutual funds, collective investment trusts, exchange-traded funds and closed end funds which are available to individual investors. To quickly summarize the major points of each type of pooled investment, check the following table:

Attributes of Pooled Investment Funds Fund Type
Open End Mutual Funds Collective Investment Trusts Exchange traded Funds Closed End Funds
Pooled Capital Yes Yes Yes Yes
Professionally managed Yes Yes Yes Yes
Number of shares or units in existence Unlimited Unlimited Unlimited Fixed at IPO
Shares redeemable by fund company Yes Yes
Shares bought and sold on stock exchanges Yes Yes
Shares may be traded at any time during market hours Yes Yes
Put and Call Options Available Yes
Typical liquidity N/A N/A High Low
Available outside of employers’ pension plans Yes Yes Yes
Available inside employers’ pension plans Usually Usually
Permitted to invest in “illiquid” securities Yes
Actively Managed funds available Yes Yes Yes
Passively Managed (index) funds available Yes Yes Yes
Share prices usually close to Net Asset Value (NAV) Yes Yes Yes
Shares may trade at a premium or discount to NAV Yes
Tax efficiency Varies Varies High Varies
Fees as a percentage of amount invested Varies Varies Low Varies
Employ leverage within the fund Up to 33% Yes Rarely 33-50%

Here, we’ll take an in-depth look at closed-end funds.

Closed-end funds (CEFs) share some of the characteristics of the other types of pooled investments, but they have some important differences that may make them attractive to certain investors in certain types of markets.

Stock ticker with IPO Out of Stock on it.

How Closed-End Funds Differ from Other Pooled Investments

Fixed Share Count

Closed-End Funds are so called because at their initial public offering the investment company offers a fixed number of shares. After that fixed number of shares is sold, they are then traded on an exchange just like an individual stock. At that time, the offering is closed and no new investment capital flows into the fund. They are the only pooled investment with a fixed share count, all other types issue new shares as required. CEFs, therefore, are more subject to price fluctuation due to supply and demand for the fund shares themselves. CEFs may trade at a substantial premium or discount to their net asset value (NAV). When they trade at a discount, this may make them seem like a bargain – however, that discount might persist for years or even get larger. The long-term average discount to NAV is 3.4% according to Blackrock, but this varies greatly from fund to fund and from time to time. This variability sometimes provides bargain buying opportunities (closed-end fund prices were generally in the dumper in late 2018, averaging a 9.3% discount to NAV), though it may seem more like stomach-churning volatility depending on how you look at it.

Diversification and Amplification of Yield of Fixed Income Investments

The great bulk of CEFs are invested in bonds, with many of those in tax-free municipal bonds. Other CEFs invest in other instruments, including stocks, corporate bonds and others. Because CEFs usually employ leverage, they are able to produce yields at higher rates than the underlying  bonds themselves. Municipal CEFs even offer tax-exempt yields. They accomplish this leverage by borrowing at low short-term interest rates and investing in longer-term bonds at higher rates. This leverage is a two-edged sword, as leverage always is. In the case of the leveraged bond ETFs, when short-term rates rise, the spread between their long-term interest income and their short-term cost of capital can narrow or even turn negative.

Liquidity

Free Trading WorkshopClosed-End Funds are definitely not a short-term trading vehicle. Because they don’t trade very widely, their bid-ask spreads vary greatly. About two out of three of the 600 or so CEFs trade under 100,000 shares a day. Their bid-ask spreads can range from just a few pennies per share to several dollars. Trading these latter could consume  two or three years’ worth of dividend income, or even more. Speaking of liquidity, the CEFs are the only one of these investment types that are permitted by regulations to buy illiquid assets within the fund – assets that can’t be sold near their NAVs in seven days or less. This permits CEF managers to invest in some things that other managers cannot, for good or ill.

There is a lot more to know about Closed-End Funds. If you are looking for a long-term investment with relatively high yields and regular quarterly (or in some cases monthly) cash distributions, are confident that you will not need to withdraw funds unexpectedly and are not going to be disturbed by high volatility, then they may merit closer attention. If so, perform your due diligence by reading all the neutral information (i.e. not offered by investment advisors or CEF providers) you can find and begin your search.


DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.