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 the need to redeem 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 that may yield a higher return. However, most CEFs offer few shareholder services. Most have dividend reinvestment plans, but little else.

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.

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 initial public offering, although nowadays, prospectuses are available anytime on the Internet.

The underlying assets of closed-end funds include municipal and taxable bonds, equity securities, international securities, and regional and single country funds. However, more than 60% of the CEFs hold bonds.

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.

Because fund shares cannot be exchanged for the underlying securities, there is usually a large difference between the share price of the fund, and the net asset value (NAV) of the fund, which is the actual value of the securities represented by each mutual fund share. This results because the actual share price is determined by the supply and demand for the shares, which usually results in a market price that is different from the fund's NAV. When a fund is first sold, the share price is often at a premium to the NAV, which is how the fund's sponsors make money in creating the fund, but eventually it drops to a discount, and remains there. If the fund's share price is higher than its underlying NAV, then the shares are said to selling at a premium over their net asset value; if the price is lower, then the shares are selling at a discount from their net asset value.

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:

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

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:

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:

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.

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 an ETF is not actively managed, whereas a CEF is; 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 buy 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 net asset value plus 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: The iShares MSCI Brazil Index ETF (EWZ:Amex) and The Brazil Fund (BZF:NYSE); The Korea Fund (KF:NYSE) 22.5% annually over the past five years; the iShares MSCI South Korea Index ETF (EWY:Amex) up 13.28% per year; The Spain Fund (SNF:NYSE) up 11.88% a year since 2000 vs. 8.44% for the iShares MSCI Spain Index ETF (EWP:Amex).