A Guide to Investing in Closed-End Funds

Explore the world of closed-end funds and gain valuable insights into effective investment strategies with Paperfree.com. Learn how closed-end funds can be crucial in diversifying your portfolio and optimizing your financial goals. This comprehensive guide covers the advantages, risks, and essential aspects of investing in closed-end funds, brought to you by Paperfree.com.

last updated Thursday, March 7, 2024
#closed end funds #closed end fund

John Burson

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Closed-end funds are a distinctive yet underappreciated investment vehicle for reaching financial goals. These funds are uniquely beneficial because they blend the best aspects of mutual funds and individual stocks, offering investors a specialized means of income generation and diversification.
Although investors have traded closed-end funds for nearly 100 years, many must understand how these funds work and their relevance as a viable investment option.

In this article, we will demystify closed-in funds by

Clearly defining closed-end funds.
Explaining how closed-end funds differ from open-end stocks
Discussing their benefits
Covering the risks
Describing the type of investors most likely to invest in closed-end funds
Answering the most common questions about this investment

What is a closed end fund?

Closed-end fund definition: A closed-end fund (CEF) raises capital for its initial investments by issuing a predetermined number of shares through an initial public offering (IPO) [1].

After the IPO, the fund doesn't issue new or redeem outstanding shares. Only the fixed number of shares offered in the IPO become available for trade on the stock exchanges.
Since investors only invest money in a limited amount of shares, no new cash flows into the fund, and little flows out.

These funds include many municipal bond funds and global investment funds.

In addition, closed-end fund portfolios are more likely than open-end funds to contain alternative assets, such as real estate, derivatives, futures, or foreign currencies.

Benefits of Closed-End Funds

Closed-end funds offer several benefits to investors, particularly those who want to diversify their portfolios and potentially increase their financial returns. Here is a rundown of the most impactful benefits.

Professional Management.
Professional portfolio managers or investment teams bring proven investing experience and keen research skills to CEF management. They control the funds using strategic investment decision-making and analysis skills to actively adjust their holdings based on market conditions and historical data. Portfolio managers’ expertise and maneuvers can potentially result in favorable investment outcomes.
Diversification.
Closed-end funds typically maintain a diversified portfolio of assets. This benefit helps investors spread risk across various asset classes, industries, and geographic regions, lessening the impact of stock and bond volatility.
Liquidity.
Since investors trade shares of closed-end funds on the stock exchanges, you can buy or sell your CEF share anytime during the trading day at the current market prices. This liquidity provides the flexibility to adjust your positions as market conditions change.
Income Generation.
Many closed-end funds use income-oriented asset allocation 3 to provide investors with regular income through dividend distributions consisting of income, capital gains, and return on capital. For this reason, these funds are attractive to income-oriented investors, such as retirees or seekers of passive income streams.
Leverage.
Some closed-end funds use leverage, meaning they borrow money to invest in additional assets. This strategy can increase the fund's risk but can also amplify returns in a favorable market. Funds using a leverage strategy usually appeal to investors with a high-risk tolerance.
Discounts and Premiums.
Closed-end fund managers often trade at prices that differ from their net asset value (NAV). These price deviations can create opportunities to increase your returns by buying shares at a discount to NAV.

Risks of Closed-End Funds

As we just covered, closed-end funds offer many benefits. However, before considering them for your portfolio, you should also consider several risks associated with them. Here are the primary risks related to closed-end funds.

Market Risk.
Regarding market risks, closed-end funds are no different than stocks and bonds. Financial market fluctuations can cause declines in the funds' NAV, potentially triggering sell-offs [4] or investor losses.
Interest Rate Risk.
Many closed-end funds are sensitive to changes in interest rates, especially those that invest in fixed-income securities. Interest rate changes can push down bond prices and decrease NAV, possibly impacting the fund's returns.
Leverage Risk.
Like with any debt-backed venture, leverage-enabled investments carry the risk of magnified losses during market downturns. So, when some closed-end funds use leverage to amplify their returns, they must factor in leverage risk in the risk/return ratio calculation [5].
Discount and Premium Risk.
Closed-end funds often trade at varying prices above or below their NAV. Although buying shares at a discount can be rewarding, the opposite is true if the discount widens or persists. This possibility can lead to capital losses.
Distribution Risk.
Income-oriented closed-end funds may be motivated to maintain high distribution levels. For this reason, these funds can deplete their NAVs over time if they lack the income to cover the distributions, potentially destabilizing sustainability.
Illiquidity Risk.
When you trade closed-end funds on the stock exchanges, you may not have the same liquidity as individual stocks. Some of these funds may have limited trading volumes, making buying or selling at your price point more challenging. This can be an even more formidable challenge in a turbulent market.

What Type of Investors Do Closed-End Funds Attract?

Closed-end funds have unique characteristics and benefits, making them suitable for specific types of investors. Let's discuss the kind of investors most likely to invest in closed-ended funds.

Investors by Qualifications
Due to their complexity and special conditions, investing in this type of fund requires the following:
- An educated understanding of financial markets.
- A willingness to research and analyze closed-end funds effectively.
- Ability to navigate the nuances associated with these investments.
- The skill to identify opportunities, such as discounts to NAV.
- Being able to make informed decisions.
  
  Even though you don't have to be an accredited investor, it certainly helps to be on the experience level of one. For example, closed-end funds often trade at discounts or premiums to their NAV. A skillful portfolio manager can leverage these opportunities for greater-than-average returns. But it helps if you know enough about the market to trust the manager’s decisions.
Investors by Preference
Many closed-end funds focus on income generation. This aspect appeals to investors seeking regular passive cash flow, such as retirees and those who depend on investments for income. Investors with long-term investment horizons also value this fund's stability and income-generating capabilities.
Many closed-end funds attract both risk-neutral and risk-averse [6] investors. However, funds that use leverage to amplify returns are better suited for investors with a high-risk tolerance. These funds also attract retail and institutional investors seeking diversification since they typically hold diversified assets across sectors and geographical regions.
Investors by Objectives and Goals
Many investors setting up an estate plan find closed-end funds efficient wealth transfer mechanisms. They provide opportunities to pass on investments with income-earning potential to beneficiaries, although plenty of due diligence is necessary to ensure they pick the suitable funds for their needs.
Since there is the potential to buy closed-end funds at a discount, contrarian [7] and value investors often use these funds for opportunities to purchase shares priced below their NAV and profit from the potential appreciation. These funds also appeal to liquidity-seeking traders because these investors can trade the funds on the stock market, which is subject to supply and demand.

In addition, tax-conscious investors can benefit from the tax-efficient structure of closed-end funds, especially if they want to minimize tax liabilities.

Closed ended funds vs open ended

How Closed-End Funds Differ from Open-End Funds?

A CEF is similar to an open-end fund in two significant ways.

It invests in securities within a portfolio.
It uses a manager to control investment activities.

However, the big difference is that CEFs don't receive a regular capital inflow when investors purchase shares. And these funds don't lose capital flow when investors sell shares.
Unlike open-end funds, there are no direct share trades with the sponsoring fund family after the initial public offering. Instead, the trading only happens with investors in the market exchanges. Since closed-end funds seize providing new shares after the IPO, investors refer to the offering as "closed."

As a result, the only ways capital can flow out of a CEF are:

shareholder distribution,
bad investment decisions,
when the fund makes a tender offer to repurchase shares,
forced sales to meet leverage compliance limits,
fund liquidation.

Most traditional mutual funds and ETFs continually receive new investor money, issue new shares, and buy back shares from shareholders. On the other hand, closed-end funds use the stock exchange to make shares available for trade throughout the trading day.

Another significant difference is that open-end mutual funds use the portfolio's net asset value to price their shares at the end of each trading day. By contrast, the stock price of a closed-end fund behaves according to the forces of supply and demand and the fluctuating values of the fund's holdings.

Q&As

How do I invest in closed-end funds?

You can buy a closed-end fund just as you would buy a stock or bond through your broker, online or brick-and-mortar. However, when you purchase shares in a closed-end fund IPO, your price will include a premium [8] to cover the expenses and fees paid for the offering. For example, suppose you paid $15 for a share with a $3.00 premium. In this case, you invested $12 in the fund during the IPO.
However, the most significant aspect of investing in closed-end is not a simple process. Instead, effectively investing in the right closed-end fund requires the following:

In-depth knowledge of the risks and rewards of the CEF's investments
Factoring in the fee expense
Knowing whether the effective leverage is 35% or less of assets
Determining whether the distribution is primarily income-funded
Finding out whether the discount to NAV is more significant than average

Where Do I Find the NAVPS, and How Do They Calculate It?

You can often find a fund's net asset value per share (NAVPS) near its price quote with your broker's online financial platform or other broker portals. Since it experiences daily calculations, the NAVPS may differ slightly from the fund's actual market price.
The calculation for NAVPS is the fund's net asset value (total assets minus liabilities) divided by the number of outstanding shares. Since closed-end funds don't add new shares, the number of outstanding shares typically remains constant. Investors use this metric to compare the fund's performance against market industry benchmarks, such as the NASDAQ.

What's the Difference Between a CEF NAV and Stock Prices?

The primary difference between CEF NAV and stock price involves their systems of measure. Common stock issued by a listed company derives its value from market demand only. On the other hand, the value of a closed-end fund depends on the amount of capital invested in the fund, the cost of running it, and its outstanding shares, as indicated by the NAVPS.

Unlike a stock price, the CEF NAV doesn't have a performance metric for the fund. Since the CEF distributes almost all the income and realized capital gains to the CEF shareholders, the NAV is ineffective in measuring fund performance. Instead, investors measure CEF performance by its total return, which includes the performance of underlying securities and dividend payment history.

Can I Invest in Closed End Funds Through ETFs and ETNs?

You can get exposure to closed-end funds with an exchange-traded fund or exchange-traded note investment. For example, Amplify High Income ETF (YYY) tracks the performance of the ISE High Income Index.

The ISE High Income Index lists 30 closed-end funds ranked according to income yield, the discount to the NAV, and liquidity. If you invested in CEFs through Amplify High Income Fund, you would currently pay about $10.88 per share for a yield of around 2.4% [9]

What is the Best Price Position for a Closed End Fund?

The best time to buy shares in a closed-end fund is when its discount exceeds the average. On the other hand, paying a premium to invest in a closed-end fund is risky because you would be paying more than the worth of the underlying assets.
Since individual investors primarily own closed-end funds, down markets usually spark a high-selling activity in these funds. This activity causes the closed-end fund discount to net asset value to grow wider. At this time, investors can buy shares of closed-end funds at discounts more significant than average.

What is The Most Compelling Reason to Invest in Closed End Fund?

The most compelling reason to invest in closed-end funds is that many are available at bargain basement prices in specific periods. They can also trade below NAV and can pay double-digit yields. However, you must stay abreast of the market to take advantage of this opportunity.

Why Paperfree.com

Closed-end funds offer many of the same advantages stocks and mutual funds provide. However, they pose an equal number of risks that require considerable due diligence and informed decision-making. Paperfree.com can help you with this challenge. We are an investment company that provides access to vetted investment opportunities in real estate and private equity for individuals seeking optimal returns on their investments.
Our magazine section and subscription newsletters offer in-depth and updated investment information and critical investment trends. To enhance your investor experience, sign up for Paperfree.com to get personalized content and access to wealth-building investment opportunities.

Sources

[1] Initial Public Offering/ Investor.gov. https://www.investor.gov/introduction-investing/investing-basics/glossary/initial-public-offering-ipo

[2] Net Asset Value/ Investor.gov. https://www.investor.gov/introduction-investing/investing-basics/glossary/net-asset-value

[3] Beginners’ Guide to Asset Allocation/ Investor.gov. https://www.investor.gov/additional-resources/general-resources/publications-research/info-sheets/beginners-guide-asset

[4] What is a Sell-Off? https://www.investopedia.com/terms/s/sell-off.asp#:~:text=What%20Is%20a%20Sell%2DOff,as%20market%20psychology%20turns%20pessimistic

[5] Risk/Reward Ratio/ Moneywise https://moneywise.com/investing/risk-reward-ratio-what-it-is-and-how-to-calculate-it

[6] What Is Risk Neutral? /Investopedia https://www.investopedia.com/terms/r/riskneutral.asp#:~:text=Risk%20neutral%20describes%20a%20mindset,risk%20averse%20to%20risk%20neutral.

[7] What is Contrarian Investing/ Forbes Advisor https://www.forbes.com/advisor/investing/contrarian-investing/

[8] At a Premium/Investopedia https://www.investopedia.com/terms/a/at-a-premium.asp

[9] ETFs Tracking ISE High Income Index https://etfdb.com/index/ise-high-income-index/

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