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Closed-End Funds (CEFs)

Definition: A closed-end fund is a publicly traded, professionally managed, investment company, designed to manage a fixed pool of capital for its investors.

CEFs normally have clear investment objectives.

There are three general types of closed end funds:

  • Bond Funds Ė These are the largest types of CEFs. The tax-exempt municipal bond funds are the most popular funds in this category. Bond funds pay good dividends and invest in long-term debt instruments. They provide solid returns, with secure and stable principal values.
  • Equity Funds Ė They employ various capital appreciation strategies and income producing techniques.
  • International and Emerging Market Funds Ė They invest in specific geographical locations, and are particularly suited for investors looking for foreign exposure. These single-country portfolios are very attractive investment vehicles.  

Defining Features of CEFs:

  • CEFs are portfolios of investments run by investment professionals. These funds are governed by boards of directors, who appoint investment advisors and portfolio managers.
  • Closed-end funds have a stable capital base, and are evidenced by a relatively fixed number of shares outstanding. These funds raise capital by selling shares, (typically in an IPO or through secondary offerings), rights offerings, or the issuance of shares for dividend reinvestment.  Subsequent trading of shares is done on the stock exchanges, not through the fund. The trading of shares in the secondary market has no effect on the fundís cash flow. This results in a constant, and more manageable, inflow and outflow of cash.
  • The stock values trade independent of the fundís net asset values. The fund price can sell at a discount or premium to its net asset value. The ranges vary, normally from a 5% premium to a 25% discount of net asset values. Typically, CEFs sell at a discount, but donít automatically rule out CEFs selling at a premium. Their investment mix may contain a valuable asset not reflected in their NAV. Conversely, not all CEFs selling at a discount are bargains. You may, however, be able to find a fund trading at an unusually large discount, which may be an excellent buy. You need to be inquisitive!
  • CEFs can leverage their balance sheets. CEFs are run like corporations; they can enhance their returns by leveraging their capital. This is accomplished by the issuance of debt or preferred stock, which is hopefully invested in assets that return more than their cost of funds.
  • CEFs can contain illiquid investments and are suited for the long-term, mainly due to their fixed capital base. This enables them to be composed of longer-term securities, such as muni bonds and other debt instruments, emerging market securities, reorganizations, and private placement deals. While many of these private deals can be very lucrative, interim reported values may involve accounting estimates. Illiquid deals can also be very risky and hard to value.  
  • CEFs can be purchased or sold throughout the day. Trading instructions, such as limited and stop orders, are also available.
  • CEFs normally do not pay corporate income taxes. Like mutual funds, taxes are passed through to the shareholders. For investors in taxable accounts, any interest, dividends and capital gains are subject to taxes. CEFs held in tax deferred accounts, such as IRAs or 401k plans, are not subject to taxes until the funds are withdrawn.
  • Income distributions are usually clearly defined and made according to a prescribed schedule.

Differences between CEFs and Mutual Funds:

Closed-end funds have a fixed capital structure. Trading of shares is done on the stock exchanges, throughout the day, without affecting the operations of the fund. Mutual funds, however, have an open ended capital structure. New purchases and redemptions are made directly through the fund, processed at the end of each day, and valued at the net asset value of the fund. Cash is constantly flowing in and out of mutual funds. A closed end fund can be more focused on long-term results, while a mutual fund is concerned with the fundís ever changing cash flow fluctuations.

The nature of the capital structure of CEFs is more complicated than mutual funds. Mutual funds are capitalized with equity, while CEFs are capitalized with a combination of equity, debt and preferred stock.

CEFs are purchased through brokerages firms; a brokerage account is required, and commissions and fees are involved. Mutual funds can be load or no load. Both funds have expenses. Mutual funds, however, have higher marketing and back-end fees. CEFs normally have lower expenses.

Purchasing CEFs at an initial IPO may or may not be a good idea. Investors purchasing IPO shares might or might not pay commissions. Any commissions, along with all the other underwriting and offering expenses, are deducted from the IPO proceeds. This is a major upfront cost that reduces the fundís net asset value and ultimately its share price. Just be careful.  

CEFs can be purchased or sold at discounts or premiums from the fundsí net asset values (NAV). Open end mutual funds always trade at the fundsí NAV.

CEFs can pay higher yields. These funds have lower expenses. They also do not need to keep extra cash on hand, or to sell securities to fund redemptions. Additionally, yields are not diluted by an unexpected influx of cash.

CEFs normally have more illiquid investments.

In conclusion, CEFs can be excellent investments. Investors just need to get comfortable with the discount/premium feature.


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