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Course 404
Closed-end Funds

Introduction

Even though they have been traded in the U.S. for over a century, closed-end funds (CEFs) are not well understood. A common misunderstanding is that a closed-end fund is a type of traditional mutual fund or an exchange-traded fund (ETF).

A closed-end fund is NOT a traditional mutual fund that is closed to new investors.

At its most fundamental level, a CEF is an investment structure (not an asset class), organized under the regulations of the Investment Company Act of 1940. A CEF is a type of investment company whose shares are traded on the open market, like a stock or an ETF.

Why are they called "Closed-End" funds?

Like a traditional mutual fund, a CEF invests in a portfolio of securities and is managed, typically, by an investment management firm. But unlike mutual funds, CEFs are closed in the sense that capital does not regularly flow into them when investors buy shares, and it does not flow out when investors sell shares. After the initial public offering, shares are not traded directly with the sponsoring fund family, as is the case with open-end mutual funds.

Instead, shares are traded on an exchange, typically, and other market participants act as the corresponding buyers or sellers. The fund itself does not issue or redeem shares daily.

Like stocks, CEFs hold an initial public offering at their launch. With the capital raised during this IPO, the portfolio managers then buy securities befitting the fund's investment strategy.

Capital Inflows and Outflows

After the IPO, there are only 5 ways to increase capital within the portfolio of a closed-end fund:

  1. Making sound investment choices that appreciate and thus increase the net asset value
  2. Issuing debt, thereby leveraging the fund
  3. Issuing preferred shares, thereby leveraging the fund
  4. Conducting a secondary share offering (selling new shares to the public)
  5. Conducting a rights offering (giving existing shareholders the right to invest more capital into the fund in proportion to their existing ownership).

Similarly, there are only five ways capital can flow out of a CEF:

  1. Distributions to shareholders
  2. Poor investment decisions
  3. A tender offer to repurchase shares, which is a method to control discounts (see next slide).
  4. For leveraged funds only, forced sales to remain in compliance of leverage limits
  5. The liquidation of the fund

So, because capital does not flow freely into and out of CEFs, they are referred to as "closed-end" funds.

Premiums and Discounts

The "closed-end" structure gives rise to discounts and premiums. After the IPO, a CEF's shares trade on the open market, typically on an exchange, and the market itself determines the share price. The result is that the share price typically does not match the net asset value of the fund's underlying holdings. (Net asset value = (Fund Assets-Fund Liabilities)/Shares Outstanding)

If the share price is higher than the net asset value, shares are said to be trading at a "premium." This is typically portrayed as a "positive discount," although mathematically that is counterintuitive. For instance, a fund trading at a two percent premium would be shown as "+2%." If the share price is less than the net asset value, the shares are said to be trading at a "discount." This is typically portrayed with a minus sign, "-2%."

Quiz 404
There is only one correct answer to each question.

1 Which statement below is true?
a. CEFs are a unique investment vehicle, combining elements of equities and mutual funds
b. CEFs are a type of exchange-traded fund
c. A CEF is simply a traditional mutual fund that is closed to new investors.
2 When you want to buy a closed-end fund, you
a. Buy shares direct from the fund company
b. Buy shares on the open market.
c. You cannot buy closed-end funds
3 What determines the share price of a closed-end fund after its IPO?
a. The net asset value of its underlying portfolio
b. The investment company
c. The market
4 If a CEF’s shares are trading above the net asset value of its portfolio, the share are trading at
a. a discount
b. a premium
c. par
5 Because of the stable asset base, CEFs can
a. invest in illiquid securities
b. issue debt and/or preferred shares
c. Both A and B
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