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Closed-End Funds
A Closed-end Fund is a publicly traded company whose business invloves investing in financial securities, like stocks and bonds. An initial public offering is when the majority of the fund's capital is raised. Once the necessary capital is raised, the fund is "closed" to new investors and the shares will now begin trading in the secondary market. When you decide to buy or sell shares of a closed-end fund, you do so on an exchange such as the NYSE, AMEX or NASDAQ. Your purchase price is determined by supply and demand forces and may be different from the Net Asset Value (NAV) of the fund. If the shares you purchased are at a price that is less than NAV, you have bought the shares at a discount. If, however, your purchase price is higher than the NAV, you paid more then the fund is currently worth - a premuim. Now that the shares are trading in the secondary market, the fund manager has a stable pool of capital from which to work with. This is in contrast to traditional open-end mutual funds whose pool of capital fluctuates as investors issue and redeem shares.
We only recommend closed-end funds when they trade at a discount to their net asset value. In many cases, this allows us to invest in a portfolio of quality companies, with quality professional management, at eighty-five to ninety cents on the dollar. Our rule is to never purchase closed-end funds as a new issue. Why, you may ask? The answer is rather simple: because when closed-end funds are newly issued, they are offered at a premium to net asset value. Why pay a premium when there are many closed-end funds available at a discount? Even if the fund manager does a terrific job with the portfolio of a fund purchased at a premuim, there are numerous examples where the share price return is substantially less than the net asset value return. Again, this is due to the share price being purchased at a premium and subsequently falling to a discount in the future. Buying closed-end funds at a discount, however, allows us to exploit some of the market inefficiencies which should help increase our overall returns. Additionally, closed-end funds allow us to gain access to some of the top portfolio managers in the industry. Again, never buy new issue closed-end funds, or funds trading at a premium to their Net Asset Value. Below, we have outlined some of the reasons why we recommend closed-end funds.
The Advantages of Closed-end Funds:
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Opportunity to buy shares at a discount to NAV - When closed-end funds can be bought at a discount to NAV, investors are buying a dollar's worth of assets for less than a dollar. -
The Yield Advantage - In income producing funds, the yield will be higher when calculated on actual dollars invested at a discount, as compared to NAV. Suppose a fund has a NAV of $10 per share, a share price of $9 a share, and generates income of $1 per year. The yield based on NAV is 10% ($1 divided by $10). If you bought an open-end mutual fund at NAV, this is the yield you would receive. But in the closed-end fund, the yield based on actual dollars invested is 11.1% ($1 divided by $9). -
Efficiency in portfolio management - Unlike open-ended mutual fund managers who must worry about constant inflows and outflows of cash as new shares are purchased and sold (redeemed), closed-end fund managers are responsible for a stable pool of capital. Having this stable pool of capital means closed-end fund managers can employ a long-term strategy, without worrying whether their fund will have enough liquidity to pay back investors who suddenly redeem shares. Closed-end fund managers can also invest in specialized areas such as less liquid securities or markets, venture capital opportunities, real estate, and private placements, etc, whereas their open-ended counterparts may not be able to. -
Trade like stocks - Closed-end funds can be purchased and sold throughout the trading day. Also, you can specify limit prices for shares of closed-end funds. This is not possible in open-ended mutual fund because all orders are placed at the end of each day, based on the closing NAV. -
Low Expenses – In general, closed-end funds do not impose 'trail commissions' or 12b-1 fees which are charged to your account, as most mutual funds do. Closed-end funds do not incur ongoing costs associated with distributing their shares as do many mutual funds; thus, the expense ratios of closed-end funds are sometimes less than those of mutual funds. Also, unlike many mutual funds that charge breakpoint fees the more money you invest with them, you can purchase closed-end funds one share at a time. -
Special Situations – Closed-end funds provide the opportunity for us to participate in rights offerings, tender offerings and in some cases, invest alongside activist investors.
The Disadvantages of Closed-end Funds:
- The fund discount may widen, especially in down markets.
- Some funds employ leverage, which can amplify losses in down markets.
- Newly issued funds are sold at a premium, something we never recommend purchasing.
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| ©2012 Blue Bell Private Wealth Management |
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