Understanding Closed-End Funds

Earlier this year, my account had a large percentage of cash. Therefore, rather than rush to buy stocks that may not be good investments, I looked for a place to put those funds. I decided that, for a portion of the account, I would use "close-end mutual funds".

I have used a closed-end fund strategy in the past. I worked for a mutual fund company for several years, and SEC rules make it very difficult for mutual fund professionals to invest in individual stocks. So I turned to alternatives, such as closed-end mutual funds.

The strategy worked quite well for me, but it often takes a lot of patience.

Most of us are familiar with the traditional mutual fund. The technical definition is that a mutual fund is a special kind of company that takes funds from investors and invests them in securities - usually stocks or bonds. A mutual fund issues shares when investors buy in, and it repurchases shares when investors withdraw funds. The purchase and sale price is determined by the market value of the fund divided by the number of outstanding shares, and this is called the Net Asset Value (or NAV).

Another name for this type of mutual fund is "open-end mutual fund". It is called "open-end" because it receives and disburses funds on a daily basis using the NAV.

A "closed-end" mutual fund also has a NAV, which is the market value divided by the number of shares outstanding. However, this kind of fund does not take or disburse investor funds on a daily basis. Therefore, investors cannot buy or sell the fund at the NAV. They must trade it like a regular stock on a secondary stock market. Indeed, these funds are often erroneously listed as stocks by online databases.

The trading price will often deviate from the NAV, sometimes trading at a discount and sometimes trading at a premium. Logically, a closed-end fund's trading price should not deviate significantly from the NAV, because the NAV represents an objective valuation of the fund. It would be a little like finding two identical US treasury bills priced differently.

In theory one could arbitrage any discount or premium. However, one can usually find such funds trading at a 10-15% discount or premium to NAV. Why is this?

There are several reasons why these disparities occur.

1. These funds are usually thinly traded, so it doesn't take much to move the price in either direction. One such fund with the ticker, BIF, moved from a modest discount to a 60% premium in a matter of months, ending in January, then settled back to a more normal 10% premium. As a result of being thinly traded, large institutional investors can't make money off of them or arbitrage the pricing discrepancy.
2. I am often suspicious why these funds would choose to be closed. Sometimes, the reasons are noble: the fund manager believes that inflows into the portfolio would disrupt the portfolio and/or hurt existing investors. More often, however, the reasons are not noble: the fund manager fears outflows will result in a smaller asset base, and thus lower fee income.
3. These funds tend to be ignored and misunderstood by investors. Disclosure is generally fairly poor, as it is with most mutual funds. With nobody paying attention, significant disparities are likely to occur.

Why did I choose to buy these funds? I buy only funds at a discount, and usually sell them when they trade at a premium. I buy them for three reasons.

1. It offers a cheap way to buy a mutual fund - you pay a stock commission, not a mutual fund commission or transaction fee. At my old broker, that was a significant savings.
2. Payouts are leveraged - for free (no interest charges). The dividends and other payouts accrue to the NAV, not to the trading price. For instance, I own an inflation-adjusted treasury fund that yields around 5% at NAV and trades at a 11½% discount. This is essentially equivalent to a short-term bond fund. However, the yield at the market price is around 5.6% (note, the yield is likely to decline in the coming months).
3. Sometimes the discount will close. This can happen from market price action, or it can happen through a single event. When funds trade at a significant discount, there is pressure on the boards to do something about it. Boards can do several things: they can convert the fund to an open-end fund; they can repurchase shares at the NAV; they can merge the fund with other funds (either open or closed); or they can increase the distributions. This generates a free return equivalent to the discount. Of note, this does not always happen, and can take a long time to happen.

What are the risks? There are always risks. There are the usual risks inherent in owning mutual funds - if it is a stock fund, then it is exposed to the returns on stocks. Mutual funds themselves as investment vehicles are subject to agency costs and agency risks - the fund manager and board often do not act in the investors best interests. The lack of liquidity can be a problem, though less so for the small investor. The leveraged payout can work against you if it represents embedded capital gains. And, finally, these funds have a higher liklihood of being managed by nimkompoops - these fund managers tend to do wierd things.

In all, however, I find it to be a useful strategy. My fund strategy has modestly outperformed the market this year, though that is more a function of the defensive and non-domestic characteristics of the funds than of any brilliance on my part.

Comments

[Chamois16]

It seems like someone who has worked in the field would know that closed-end funds are not mutual funds. The misuse of the term destroys the validity of whatever point is being made.

"Closed-End Funds

"A "closed-end fund," legally known as a "closed-end company," is one of three basic types of investment company. The two other basic types of investment companies are mutual funds and unit investments trusts (UITs)." -sec.gov

[dc]

They are actually a type of mutual fund, whatever the technical legal term used. They are operated identically to a mutual fund, except for the way they are bought and sold. They are regulated like mutual funds. They are run by mutual fund companies, sometimes as duplicate funds of other open-end funds. I'm not sure how the term-splicing destroys the validity of the point.

[dc]

This is my second attempt at posting this.

The technical legal name for the two types of funds under the Investment Company Act of 1940 are: "closed-end management companies" and "open-end management companies."

Except for purchases and redemptions, the two types are nearly identical.

[Chamois16]

Closed end funds,,as you say, are like mutual funds in many ways, but they are not mutual funds. Here's one clip from sec.gov

Mutual Funds

A mutual fund is a company that pools money from many investors and invests the money in stocks, bonds, short-term money-market instruments, or other securities. Legally known as an "open-end company," a mutual fund is one of three basic types of investment company. The two other basic types are closed-end funds and Unit Investment Trusts (UITs).

There are enough differences within the ICA 1940, to mse the distinction worthwhile.

[Chamois16]

Sorry for the PS, but my response was truncated. The point was that if one is going to give a tutorial on "understanding closed-end funds," why not accurately make the distinction? With the explosion of "managed index" ETF, financial advisors who fail to make the important distinctions among investment vehicles and the difficulty in understanding why CEF prices, unlike those of mutual funds, stray significantly, and for good reason, from NAVs, investors have enough problem reconciling the conflicting statements by experts in the field. JMO as always