Closed-End Mutual Funds

A closed-end mutual fund, also known simply as a closed-end fund (CEF), sells shares of the fund in an initial public offering (IPO). After the offering, no more shares are created or redeemed. Therefore, less money is needed to manage the fund, since there is no need to deal directly with individual investors, such as sending periodic statements, and it also eliminates redeeming shares to pay investors who want to cash out, such as occurs in open-end mutual funds. Consequently, a closed-end fund can be more fully invested, since it doesn't need as much cash, and it is more tax efficient. Because CEFs do not have to redeem shares, they can invest in more illiquid securities or longer-term debt that may yield a higher return. However, most CEFs offer few shareholder services. Most have dividend reinvestment plans, but little else.

Sometimes when an open-end fund receives too much money to invest profitably, the managers will close the fund to new investors. It is still an open-end fund, in that it continues to operate as an open-end fund, and existing shareholders can continue to buy or redeem shares from the fund or reinvest profits, but it is closed to new investors. So a closed open-end fund is not a CEF.

Trades of closed-end funds can be transacted on an public exchange like stocks or from brokers. IPO issues can only be obtained from brokers. However, broker commissions are higher than commissions on exchange transactions. Additionally, spreads between the bid and ask price can be large, especially for thinly traded CEFs, where only a quote from a broker-dealer may be available.

The main advantages of CEFs over mutual funds is that they do not have to maintain liquidity for redemptions and they can typically be bought at a deep discount to their net asset value. Because CEFs are bought mainly for their income, being able to buy at discount can significantly increase the yield of the investment. Moreover, the fund manager may decide to liquidate the fund if it consistently sells at a discount, in which case, investors will receive the net asset value. The main possible advantage over exchange-traded funds (ETFs) is that CEFs are actively managed and can use leverage to increase returns. Unlike open-end mutual funds, and they can issue debt or sell preferred shares to increase their leverage, which will hopefully increase profits. Price quotes can be obtained from Morningstar or from Closed End Fund Quotes at NASDAQ.com The net asset value (NAV) of the CEF is determined by its underlying securities minus the fund's liabilities:

NAV = (Assets – Liabilities) ÷ Issued Shares

Net asset value is composed of the following:

Disadvantages of CEFs include higher management expenses compared to no-load mutual funds or index funds and CEFs are only required to disclose their portfolios quarterly or semiannually. CEF shareholders who are registered on the ex-dividend date must pay capital gains taxes regardless of how long they held the CEF shares. Furthermore, some income earned from municipal bonds held by the CEF may not be exempt from the alternative minimum tax.

The underlying assets of closed-end funds often include municipal and taxable bonds, equity securities, international securities, and regional and single country funds. However, more than 60% of the CEFs hold bonds. Closed-end funds were far more numerous than open-end funds in the 1920's, but since many of them were highly leveraged, their number was greatly reduced by the stock market crash in 1929.

Because CEFs are sold on the market, large market orders can have a significant effect on the price. Other factors that affect CEF prices include relative performance, annual yield, amount of illiquid total holdings in the portfolio, the amount of unrealized appreciation in the portfolio, and the name recognition of the fund's manager.

CEF Initial Public Offering

The money from the IPO is used to buy a specific portfolio of securities that satisfies the advertised investment objective of the fund. Thereafter, shares of the company are bought and sold over a stock exchange or over-the-counter, just like any stock. A prospectus is only offered for a CEF during the IPO, although nowadays, prospectuses are available anytime on the Internet. Managers of CEFs buy and sell securities continually, so even though the number of CEF shares is fixed, the underlying portfolio is not, so CEFs are actively managed, resulting in higher expenses. Furthermore, the fund portfolio may drift from the CEF's stated objective, possibly lowering returns.

A CEF begins as an idea by a fund manager who thinks that a particular type of CEF with a particular fund strategy will be attractive to investors. If the manager is not in the business of creating CEFs, then one can be sponsored by a CEF fund. However, to succeed, the CEF must have the support of a sufficient number of underwriters, who set the price for the shares and the fees charged. Often, they will require a certain minimum distribution rate to facilitate selling the issue to the market. Then the CEF must proceed to satisfy regulations, paying legal costs and regulatory filing fees, and for the cost of creating and distributing prospectuses.

There are several disadvantages to investing in a CEF IPO. Unlike the corporate IPO, a CEF has no history for which to gauge performance, since the securities that underlie the CEF are not even purchased until after the IPO. The purchase of the underlying securities to satisfy the CEF's investment objectives may occur when prices are higher, but the securities must be bought so that distribution commitments can be satisfied. Furthermore, CEF share prices will always be at a premium during IPO and shortly thereafter because underwriters and their brokers sell the shares and charge a commission, referred to as a sales load, of 4.5%. Additionally, some of the IPO proceeds are used to pay for expenses of bringing the CEF to market. An additional 0.10% to 0.25% of the share price is used to pay for offering expenses, such as filing and legal fees.

Total Return and Distribution Rates

The true value of a CEF is determined by its total return, which is the change in its share price plus the distributions for the year, not its distribution rate:

Total Return = Share Price Change + Distribution Rate

Distribution Rate = Total Annual Distribution ÷ Share Price

The other way of calculating the distribution rate is to divide the total annual distribution by the net asset value:

Distribution Rate = Total Annual Distributions ÷ NAV

The total return of CEFs is far more important than the distribution rate.

There are 3 dates in regards to distributions:

In most cases, the price of the CEF will decline approximately by the amount of the distribution, since the NAV also declines by the amount of the distribution. A discounted CEF will decline less, whereas a premium CEF will decline more.

CEF Expenses

Expenses reduce the return of any fund — the higher the expense, the lower the return. One metric used to compare different funds is the expense ratio, = expenses ÷ average net assets.

Because CEFs are smaller than mutual funds, expenses must be distributed over fewer assets, thus, raising the expense ratio.

An unfortunate provision of the Investment Company Act is that CEFs only have to include interest expenses in reporting their expense ratios, so the dividends paid to preferred shareholders of a CEF are not included as an expense in calculating the expense ratio, even though the preferred dividend is a paid liability. To more accurately compare different funds, some market reports include the adjusted expense ratio, which is the expense ratio minus the interest expenses.

Leverage

CEFs use leverage to increase returns, but leverage also increases volatility and potential losses. Leverage is the use of debt instead of shareholder equity to purchase assets. The Investment Company Act of 1940 requires a CEF to report its total leverage ratio, including loans, lines of credit, and notes payable. The leverage ratio is the asset value divided by the value used to purchase the asset, so if an asset cost $100,000 on which the CEF puts down $20,000, then the leverage ratio is 5 to 1 or 80%, because 80% of the asset is purchased with borrowed money.

Leverage is achieved by issuing debt or preferred shares, so one of the risks of leverage is that assets may have to be sold to pay interest to the providers of leverage. Unlike open-end funds or ETFs, the Investment Company Act of 1940 allows CEFs to issue debt, in amounts of up to 50% of NAV or, for preferred shares, up to 100% of NAV. The average is about 33%, meaning that the CEF has $.33 of debt for every $1 of NAV.

Because preferred shares and debt are allowed by the Investment Act of 1940, these types of debt are referred to as 40 Act leverage. However, some CEFs use non-40 Act leverage, including:

Although all leverage is reported in financial statements of the CEF, only 40 Act leverage needs to be reported as leverage. Hence, some CEFs misleadingly advertise themselves as being unleveraged — meaning that they have no 40 Act leverage — but they may have substantial non-40 Act leverage. The risks of leverage are the same for both 40 Act and non-40 Act leverage. Regardless of the type of leverage, an investor can easily determine the total leverage used by the following equation:

Leverage Ratio = Total Assets ÷ Net Assets

The percentage by which the above equation exceeds 1 is equal to the amount of leverage being used by the fund. Leverage is only beneficial if the income earned from the leveraged assets exceeds the expenses of the leverage.

The leverage ratio of debt to total assets should not exceed 40%; higher levels will cause the fund to decline more rapidly in a down market or when interest rates rise. Too much leverage limits the ability of the fund to borrow more and may force it to sell assets in a down market for less than their actual value.

Discounts and Premiums

Because fund shares cannot be exchanged for the underlying securities, the share price of the fund usually differs from the net asset value of the fund, calculated by the CEF daily after subtracting expenses, which is the actual value of the securities represented by each CEF share. Premiums and discounts result because the supply and demand for the shares usually differs from the supply and demand for the underlying securities and, unlike exchange traded funds, no method of arbitrage is provided to eliminate the premium or discount. Therefore, a CEF may trade at an absolute premium or, more often, at an absolute discount to its NAV. Other reasons for the premium or discount include:

The discount or premium is calculated thus:

Premium/Discount = Share Price ÷ NAV – 1

If the above equation is positive, then the CEF is selling at a premium; otherwise, it is selling at a discount. So if the share price = $9, but the NAV = $10, then the discount = 9/10 – 1 = -0.1. There is always a premium on an IPO offering, because the offering price usually includes a sales commission of about 5%. The premium may even be maintained for at least a couple months by the underwriters to support the issue, but they will eventually stop, causing the CEF to fall to a discount. For these reasons, investors should never pay a premium for a CEF because losses will be incurred when it falls to the inevitable discount. In most cases, the same investment strategy can be achieved with other CEFs or other types of funds without paying a premium. Most CEFs trade at a discount, often 10% or more.

Measuring Relative Premiums or Discounts with the Z-Score

A relative premium or discount is related to the average of a particular CEF class or fund. Studies have revealed that current premiums or discounts tend to move toward the average premium or discount rather than to its NAV.

Relative discounts or premiums are measured as a z-score:

Z-Score = (Current Discount or Premium – Average Discount or Premium) ÷ Standard Deviation of Average Discount or Premium

Example 1: Calculating the Z-Score of a CEF

Example 2: Calculating the Z-Score of a CEF

A z-score between +2 and -2 means that the discount or premium is close to average historical values for that CEF; values above +2 means that the premium is greater than the historical average or that the discount is less than average; z-scores below -2 means that the premium is less than average or that the discount is greater than average. If the z-score is less than -2, then it is more likely to be a better buy. However, the absolute premium or discount should not be disregarded, especially if the absolute premium is in the double digits. Discounts increase a CEF's yield, while premiums decrease it.

Note that current discounts or premiums can also change because of impending corporate actions. For instance, if a CEF would decide to liquidate, meaning that all of the assets would be sold and the equity of the fund would be distributed to its shareholders, then the discount or premium will disappear because investors would receive a value equal to the NAV. Hence, interpretation of a high or low z-score is not necessarily straightforward, but should be investigated as to its cause.

CEF Distributions

Investors receive income from distributions. CEFs generally offer a schedule for the distribution of current income and capital gains, which allows investor planning, but the composition of the distribution may change by year-end. Distributions cause the price of discounted funds to fall less than by the amount of the distribution; likewise, the price of premium-to-NAV funds falls more.

As registered investment companies (RICs), CEFs are not taxable entities; instead, investors pay taxes on the distribution, which eliminates double taxation that would result if the CEF was a taxable entity. However, to maintain its RIC status, the CEF must distribute, by calendar year-end, at least 90% of its net investment income. However, a 4% excise tax on undistributed income may be assessed unless at least 98% of ordinary income is distributed by calendar year-end and 98.2% of net realized capital gains is distributed by October 31 of the calendar year. However, CEFs do tend to keep some undistributed net investment income, increasing the NAV, to fund future distribution commitments.

There can be 4 components to a CEF distribution, reported on the Form 1099-DIV:

  1. interest
  2. dividends
  3. realized capital gains
  4. return of capital, consisting of:
    1. a pass-through return of capital, usually from master limited partnerships
    2. constructive return of capital, from unrealized capital gains
    3. destructive return of capital, in which the investors are receiving their own invested capital back, minus expenses.

A return of capital is defined as the amount distributed that exceeds interest, dividends, and realized capital gains for the relevant period.

Because a CEF distribution is composed of various sources of income, the investment return on a CEF is referred to as a distribution rate rather than as a yield or interest. The distinction is important when it is taxed, since dividends, interest, and capital gains are taxed differently and a return of capital is not taxed at all. Furthermore, the interest and dividend portion of the distribution is more stable, while capital gains are more erratic. A return of capital is not sustainable and if it is destructive, then the value of the fund will decline, lowering the distribution and the share price.

Investors cannot know the composition of the distributions until they receive a Form 1099-DIV, Dividends and Distributions in January for the previous year. Any previous information regarding the distribution composition were estimates. Potential investors can only get this information from the CEF's annual statement. Morningstar also has this information for previous years.

Return of Capital

A return of capital is done for various reasons. Fund managers, as part of their distribution policy, use it to maintain a large distribution, so that a large CEF discount is avoided. Investors also like to receive consistent income, so a return of capital helps to cover shortfalls in the other components of a distribution. Managers of equity funds manage distributions by seeking an exemption from Rule 19(b) f the Investment Company Act of 1940, which prohibits distributing long-term capital gains more than once per year.

To determine distributions for the year, managers must estimate the amount of income that they will earn from their various sources. Usually, actual earnings will differ from the estimate, so shortfalls are frequently covered by a return of capital.

A return of capital is not necessarily a red flag. Some return of capital is a pass-through return of capital from the underlying assets, mostly master limited partnerships, covered call funds, or even other CEFs. (Yes, a CEF can own another CEF!)

A manager may also return some capital to maintain a distribution commitment without selling a capital asset that is expected to appreciate more: constructive return of capital. For instance, a CEF may own valuable stock that is expected to continue increasing in price, so the manager does not want to sell it to maintain a distribution commitment. Instead, some of the distribution is composed of cash held by the CEF, which is a constructive return of capital. It is constructive because an appreciating asset earns money while un-invested cash earns nothing. Of course, since the actual components of the distribution are only estimates during the year, it may turn out that the manager decides to sell the stock before the year end, in which case, the constructive return of capital would be recharacterized as realized capital gains. Any constructive return of capital comes from either cash on hand or unrealized capital gains.

A destructive return of capital is the worst kind, where the CEF is simply returning some of the capital that the investors paid in, minus the expenses, to maintain the distribution rate. The 2 sources of destructive return of capital are cash and unrealized capital gains. A lower distribution rate will cause the CEF share price to decline. However, a destructive return of capital always decreases the amount of assets earning income, making it more difficult to maintain the distribution rate. Unless the CEF improves its investment performance, the distribution rate, along with the share price, will have to decline, yielding losses for its investors. A destructive return of capital causes the NAV plus distributions to decline continually.

Some fund managers purposely set distribution rates higher than what the fund can actually earn, which boosts share prices temporarily, sucking in investors who haven't performed due diligence in looking at the actual source of the distributions. Such investors will surely incur losses! A destructive return of capital is easily recognized, since the sum of the NAV plus distributions at the end of the year is no greater than the NAV at the beginning of the year. If the NAV is lower at the end of the year, but not lower than by the amount distributed, then there was a partial destructive return of capital.

Monthly or quarterly distributions from a CEF include an estimate of how much of the distribution is a return of capital, but the actual amount will only be revealed in the year-end Form 1099-DIV, which is what must be used for filing taxes, since the return of capital is not taxed. Return of capital lowers the taxpayer's cost basis in the shares, so taxes are deferred until the shares are sold. So if you bought a CEF for $10 per share and received a return of capital of $2 per share, then your cost basis will be $8 per share. If you subsequently sell the shares for $10, then you have a capital gain of $2 per share.

CEF Evaluation

When evaluating a CEF, investors should look at the share price compared to the NAV, at least 1 year of Z statistics, the leverage ratio, and the distribution rate, and the reasons underlying the value of each component. An investor should perform due diligence if the premium is greater than 10%; usually, however, it is best to buy a CEF with at least a 10% discount.

When looking at the distribution rate, the source of the distribution should be examined. If part of the distribution is a return of capital, then the fund's NAV will decline over time, forcing the CEF to lower its yield, causing a decline in price. The return of capital of a CEF can be found at the closed-end funds association website: www.CEFconnect.com.

Discount-to-Expenses Ratio

One metric used to analyze funds selling at a deep discount to their NAV is the discount-to-expenses ratio, dividing the percentage discount by the expense percentage:

Closed-End Fund
Discount-to-Expense Ratio
Formula
Discount-to-Expense Ratio =Discount %
Expense %

Let's take a real example. Here's a quote from the Closed-End Fund Association, a very useful site about closed-end funds:

As of 12/22/2005 As of 11/30/2005
Name Symbol/
Exchange
NAV Prior
NAV
Market
Price
Market
Price
High
Market
Price
Low
Premium
Discount
YTD Market
Return
YTD NAV
Return
1-Yr.
NAV Return
Equus IIEQS
NYSE
12.2712.279.009.19-26.6521.1417.9821.54

With a market price of $9 and a NAV of $12.27, this fund is obviously selling at a discount. To find the discount, or premium if the market value is greater than the NAV:

Discount | Premium Percentage Formula
Discount | Premium Ratio
(Discounts < 0, Premium > 0.)
=Market Price - NAV
NAV
Discount | Premium Example
$9 Market Price - $12.27 NAV
$12.27 NAV
= -26.65% Discount

Of course, you can see the discount in the quote above, but now you know how it is calculated.

We find that the expense ratio is 3.83, rather high for any fund, let alone a closed-end fund, but this is just an example calculation. (The high expense ratio may be the reason why the fund has been selling at a deep discount for the past 10 years, with an average discount of 31.99% according to this site.) So now we plug in the numbers:

Discount-to-Expense Ratio Example
26.65%
3.83%
= 6.96

Never buy a fund based only on this metric, but it is useful for comparing funds, especially funds specializing in a country or a sector. Generally, a fund with such a high expense ratio, even selling at a deep discount, is not a good investment, and as you can see, the discount-to-expense ratio is rather low even with the big discount percentage. This ratio should be greater than 10. The discount-to-expense ratio is more useful in comparing country or sector funds, since these funds may have unique expenses that don't allow easy comparisons with other types of mutual funds. If this fund had an expense ratio of 1%, its discount-to-expense ratio would be 26.65—a big difference.

CEF Buying Tips

Before buying a closed-end fund, keep these points in mind:

For the reasons stated above, it is best never to buy a fund as part of an IPO — buy it on a stock exchange, especially if it is trading below its NAV and especially if it pays interest, since a CEF trading at a discount will have a higher yield.

Differences Between an Exchange-Traded Fund (ETF) and a Closed-End Fund (CEF)

Exchange-traded funds (ETFs) and closed-end funds both derive their value from the portfolio of securities that they contain, and both trade on stock exchanges just like a stock. The fundamental difference between the two is that most ETFs are not actively managed, whereas CEFs are; consequently, ETFs have lower expenses. The value of both is also constrained by their NAV, but CEFs much less so than ETFs, because market specialists and institutional traders, known as authorized participants, keep ETFs valued closer to their NAVs through arbitrage.

However, there are special types of CEFs that can keep the market price closer to the NAV of the fund by periodically buying back their shares. Interval closed-end funds may purchase 5 - 25% of outstanding shares at intervals of 3, 6, or 12 months. Discretionary closed-end funds may buy shares from investors once every 2 years or so at the NAV minus a repurchase fee of 2% or less.

Buying a CEF at a discount increases the effective interest rate, since the income received is not affected by the market price of the CEF. However, because a CEF is actively managed, this creates more expenses for the fund and more capital gains taxes for the investor. Whether CEFs do better than ETFs depends on whether the manager can outperform the indexes enough to overcome the greater expenses, and so, in evaluating a CEF, one needs to assess the manager's ability by looking at his experience and the performance of the fund under his direction.

This article, ETFs vs. Closed-End: Read the Fine Print - TheStreet, discusses several country funds, especially where a country fund has both an ETF and a CEF, and concludes that CEFs are generally more profitable than ETFs. Examples: