CEFs allow investors to access professionally-managed portfolios, often at a discount to the value of the underlying assets
Investment funds come in all shapes and sizes providing investors with the ability to diversify their investments. By far, the largest category of investment funds are mutual funds, which collectively hold over $16 trillion in assets. More recently, exchange-traded funds, or ETFs, have gained credibility as an option to gain exposure to a particular index or sector. However, the first pooled investment vehicles were actually closed-end funds, or CEFs, which offer a fixed number of shares and trade on the exchanges just like the stocks of individual companies.
- Potential for price appreciation
- Experienced portfolio management
- Asset diversification
- Intraday purchases and sales
- Regular, consistent distributions
- Discount-enhanced yield
Closed-end funds revolutionized investing when they were first introduced in 1883, some 30-plus years before the first mutual funds were launched. Today, closed-end funds represent a small piece of the asset management business. But with about $300 billion in assets, the industry is highly valued by investors as one of the most attractive ways to own an actively-managed portfolio of securities at a low minimum investment. In fact, Barron's recently released a list of "closed-end funds that still deliver". And while CEFs are often overlooked and misunderstood, their unique structure provides investors an important and differentiated way to achieve their long-term investment goals. Many investors hold CEFs for long periods of time and it is not unusual for shares to be handed down from one generation to the next.
Active, Professional Portfolio Management
How they are created and traded are often misunderstood aspects of closed-end funds. Typically, there is an initial public offering (IPO) to raise capital dedicated to a specific strategy or asset class. “Closed-end” funds got their name from the fact that once the capital is raised shares are no longer issued directly from the fund, although new shares may be issued through dividend reinvestment programs or secondary offerings. To purchase shares, investors go through a broker or a cash purchase plan offered by the fund’s transfer agent.
Following the IPO, closed-end funds are listed on a national exchange such as the NewYork Stock Exchange (NYSE) or the NASDAQ, where shares are purchased and sold just like any other stock. When an investor wants to buy or sell shares of a CEF, the trade occurs between investors, not with the fund company itself. This unique structure provides closed-end fund managers with several benefits that help improve internal investment processes and enhance returns for shareholders.
Among the most notable advantages is the formation of a stable asset base. Unlike mutual funds, closed-end funds do not deal with daily inflows and outflows of money. Traditional mutual funds issue and redeem shares at the close of every trading session, whereas CEFs avoid both the added transaction costs as well as the need to forcibly sell shares simply to meet redemption requests. CEF managers, as a result, can focus on strategic, long-term investments regardless of market conditions.
Investors can buy and sell CEFs throughout each day’s trading session, versus the end-of-day transactional structure of mutual funds. This allows for more control over buy and sell decisions and the ability to achieve the ideal price of a given security when purchasing or selling shares. This can be a particularly important consideration in volatile markets.
CEFs are often attractive for income investors as they make distributions to shareholders at regular intervals. Depending on a fund’s underlying holdings, distributions may include interest income, dividends, capital gains, and possibly return of capital. The CEF structure also allows for the use of leverage. While not all funds utilize debt, leverage can boost income for investors in certain circumstances.
Benefiting from the Discount
At their most fundamental level, equity CEFs are a collection of stocks. Net asset value (NAV) refers to the current market value of all the stocks a particular fund owns, minus liabilities, and divided by the number of outstanding shares. Investors might expect the share price of a CEF to be equal to the net asset value per share. However, because closed-end funds trade on exchanges, the value of the shares is determined by the market. It is the difference between the share price and the NAV that creates discounts, or in rare cases, premiums. Shares trade at a discount when the share price is lower than the NAV and at a premium when the share price is higher than the NAV.
Most often, equity CEFs trade at a discount. Academics and investors have studied CEFs for many years to explain reasons for persistent discounts and have proposed a number of potential causes, none of which are conclusive. Research suggests that funds’ distribution rates, historical performance, and underlying portfolio content may all contribute in varying degrees to the persistent discounts of CEFs. Other studies suggest that the potential tax liabilities from unrealized gains can also impact the discount or premium. The lack of advertising, fluctuation in supply and demand for the stock as well investors selling due to general market fears have also been identified as potential factors.
Many investors view the discount as a key advantage of a CEF. The discount is simply another way of saying you can buy a dollar’s worth of assets for a lesser amount, which often results in an enhanced yield for investors. To illustrate how the discount enhances yield, let’s assume the NAV equals $100 a share and the yield on NAV equals 5%, or $5 per share. An investor that acquires stock at $85 a share – a 15% discount – would generate a higher yield than someone who acquired the same shares at the NAV level. In this scenario, the yield on the CEF’s market price would equate to 5.9% versus the 5% yield on the NAV.
YIELD ON NAV
YIELD ON MARKET PRICE
$5/$100 = 5%
$5/$85 = 5.9%
Additionally, investors can also benefit from the potential narrowing of the discount over time as the CEF’s share price increases.
Taken together, the value of closed-end funds and their appeal to a wide range of investors is clear. CEFs provide access to experienced and well-regarded portfolio managers with a low minimum investment. At the same time, CEFs can provide instant exposure to a broad portfolio of investments, providing the diversification needed for consistent, risk-adjusted returns.