These quirky investments are part mutual fund, part stock.
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By Morningstar Equity Analysts | 08-29-00 | 08:00 AM | Email Article

Closed-end funds aren’t very popular these days, especially when compared with their well-known cousins, open-end funds (which are more commonly known as mutual funds). However, closed-end funds have actually been around longer, and they have some benefits that make them worth a look--as well as some disadvantages that must be taken into account. As investments, they act a little like stocks, and a little like mutual funds.

Morningstar stock and fund analysts cover 2,000 mutual funds, 2,100 equities, and 300 exchange-traded funds.

What's the Difference?
Like open-end funds, closed-end funds gather money from large and small investors alike. The combined assets are managed by portfolio managers from investment firms, some of which are the same fund companies familiar to mutual-fund investors. The value of one share of this pool of money is called the closed-end fund's net asset value, or NAV, just like with open-end funds.

Until the late 1990s, closed-end funds only determined their NAVs once a week, unlike mutual funds, which figure the value every day. Now, though, a large number of closed-end funds provide their NAVs daily. Before too long, all probably will do so.

One big difference between the two formats is that open-end funds sell new shares and redeem existing shares for investors every day, causing net assets to fluctuate--often wildly--even if the NAV isn’t changing much. But, with some exceptions, closed-end funds sell shares to investors only once, in an initial public offering (IPO). When shareholders want to sell their closed-end fund shares, they must sell to other investors through brokers, as with a common stock. Most closed-end funds are listed on the New York Stock Exchange.

The broker--whether discount, full-service, or online--gets the same commission it would if it were trading a stock. This commission is the only charge for buying the fund on the market, but it can’t be avoided. For that reason, there are no "no-load" closed-end funds--or "load" funds, for that matter, except arguably at their IPO, as explained below.

Because they trade on exchanges, closed-end funds have a second price besides their NAV. The price at which investors actually buy and sell shares is called the market price. Investors can learn the market price of a closed-end fund at any minute of the day, as with a stock price. To get a fund’s current share price on Morningstar.com, just type the ticker or name of the fund in the box at the top left of the home page, and then click on "Quote" from the menu that appears.

It’s almost never a good idea to buy a closed-end fund at its IPO. A built-in underwriting charge is included in the initial price--something akin to a load, in fact. And unlike some IPOs, a closed-end fund is extremely unlikely to rise sharply soon after its IPO. So there’s no hurry. By waiting and buying shares on the market, investors can avoid paying that underwriting charge, which can be as large as 7%.

Premiums and Discounts
The two prices of a closed-end fund means that it usually is bought and sold at a price higher or lower than its NAV. (The two prices could be identical, but they rarely are.) Most closed-end funds sell at discounts to their NAV. For years, academics and other researchers have come up with a variety of theories why that’s so, but none of the theories has proven itself consistently enough to be considered a definitive explanation.

For buyers, the opportunity to purchase a fund at a discount is a key advantage of the closed-end structure. If a fund performs well, investors may push the share price to a premium, or at least a narrower discount. Thus shareholders reap the benefits not only of the fund's NAV advance, but the exaggerated effects of its market-price movement.

Central Securities  is an example of a strong performer that saw its price move from a discount to a premium--and then back to a discount.

Of course, there is a downside to this premium/discount phenomenon, as the latter part of the Central Securities chart demonstrates. A manager could do a fine job, boosting the fund’s NAV return, but if investors grow skittish for whatever reason, the fund's market price could fail to keep up--giving shareholders a smaller gain than the portfolio itself achieved.

A discount makes closed-end funds particularly attractive to bond investors, which explains why the majority of closed-end funds are invested in bonds. Funds pay out income based on the share's lower net asset value, not the market price. That’s one reason a closed-end bond fund often pays a higher yield than a comparable open-end fund.

Another reason is that many closed-end bond funds use leverage, which pumps up their income. But it also increases a fund’s volatility and therefore its risk. When interest rates fall, the returns on leveraged bond funds are superior. When interest rates rise, leveraged bond funds get slammed.

Buying shares of a closed-end fund that is selling at a premium isn't very popular. But some investors still do it in the hope that the market price will continue to rise. Or a bond fund’s leverage might make its yield attractive, compared with alternative investments, even when the fund is bought at a premium.

No Redemptions, No Inflows
The managers of closed-end funds have one advantage over their open-end counterparts. Because closed-end funds have fixed asset bases, their managers don't need to meet sudden redemption requests from panicky shareholders, nor can they be forced to invest vast new inflows of cash in a market that already seems pricey.

This stable asset base allows a manager more peace of mind when investing in securities that trade infrequently, also know as "illiquid" securities, and would be hard to sell in a pinch. By contrast, an open-end manager is more exposed to fickle investors either flooding the fund with cash that the manager may not be able to quickly invest, or pulling out cash when stocks drop (which is the precise time many managers would like more inflows with which to buy shares at a bargain).

Sometimes closed-end funds do raise more money through a process known as a rights offering. This complicated step, which more or less forces shareholders to pony up more money to buy more shares at a time of the fund’s choosing, is unpopular with many closed-end fund shareholders. In a "transferable" rights offering, the right to buy more shares can be sold to another investor, and thus the shareholder can avoid having to buy more shares in order to maintain the same stake in the fund.

The Discount Dilemma
In recent years, many closed-end fund shareholders have become unhappy that their funds have traded at persistent discounts that seem only to get deeper. They--along with activist investors who purposely buy such funds, sensing an opportunity--put pressure on a fund’s advisor to take action to narrow the discount. Many closed-end funds have a clause in their prospectuses that forces them to consider the problems of persistent discounts, but those clauses are often loosely worded and do not require specific action.

When a fund faces a persistent discount, the advisor’s choices are:

  • Ignore it until angry shareholders force the fund to do something.
  • Hold a tender offer or buy back shares on the open market to reduce the number of shares outstanding.
  • Merge the closed-end fund into a similar open-end fund.
  • Convert the fund to an open-end structure.

The latter is the most popular option for the community of arbitrageurs who have shaken up the closed-end world in recent years. They typically buy shares of a closed-end fund trading at a deep discount and try to rally fellow shareholders to force the fund's board to switch to the open-end structure. This would allow all investors to immediately get a boost of, say, 11%, if a fund's NAV is $10 but the market price is $9 on the day of conversion.

In some cases, the activists have gotten themselves elected to the fund’s board of directors.

Few individual investors can hope to make money consistently on closed-end funds in this way. It’s just too difficult to predict which ones will open-end, and even if you do guess correctly, the fund’s price could decline in the long period before the official open-ending date so much that the potential gain can be wiped out. That’s a particular danger with funds that invest in volatile areas such as emerging markets.

In general, then, closed-end funds aren’t better or worse than open-end funds. For certain investors who want a particular fund, a higher-yielding alternative, or who simply like the idea of buying at a discount, though, they can provide a worthwhile addition to a portfolio.

Closed-End vs. Closed
A closed-end fund should not be confused with a closed fund. The latter is an open-end mutual fund that has decided to stop taking in new money--temporarily or permanently--because its management thinks that the size of its asset base has become more of a burden than an advantage.

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