What makes CEFs different?
The most basic difference between CEFs and traditional open-end mutual funds is that CEFs issue a fixed number of shares through an initial public offering (IPO). Mutual funds can issue an unlimited number of shares. This core structural difference means that CEFs trade and function differently than their far more common open-end counterparts like mutual funds and exchange-traded funds. These operational differences have implications for fund managers, not to mention investor portfolios.
CEF managers better equipped to stay the course
An overlooked potential advantage of the CEF structure is that it allows managers the freedom to take a more long-term view on the market. With CEFs, managers don’t have to worry about inflows and outflows as they do with traditional open-end funds. Because of the closed-end structure, there is a fixed pool of capital. Therefore, the market doesn’t force the buying and selling of CEF shares as it does with open-end funds.
If markets begin to dip – as witnessed during the pandemic, the Russia-Ukraine war, and further geopolitical tensions occurring in different regions across the globe – anxious investors are likely to begin pulling their money out of the equity market. This could force open-end fund managers to sell in order to raise the cash for the redemptions. They must meet this obligation whether they think selling is in the best interest of the portfolio or not. In the same scenario, CEF managers would be able to stay the course since their capital pool is fixed. Furthermore, when managers are forced to sell stocks, there may be capital gains. Because CEF managers do not have the same obligation to sell during market downturns, they’re able to manage capital gains, providing investors with yet another advantage.
Understanding discounts and premiums
Because CEF shares trade on the secondary market, investors can purchase shares at a discount to the fund net asset value (NAV), which may be advantageous.1 But there's another side of the coin – CEFs can also trade at a premium to NAV, which could be disadvantageous.
It's not as simple as that, however. Even if investors purchase CEF shares at a discount, it's possible that over time this discount could widen. Conversely, while investors who have purchased CEF shares at a premium seem to be at a disadvantage, there's always the possibility that the premium could rise over time. Discounts and premiums reflect a combination of supply and demand, performance, and yield. Supply and demand govern secondary market prices. While over the long term, performance should be the most important factor; investors can take advantage of funds trading at a discount in the short term.
Liquidity and strategy differences
Another key difference between open-end funds and CEFs is that the former have daily liquidity. Meaning their NAV is calculated at the close of each day with shares being redeemed at their NAV. CEFs, on the other hand, have the advantage of intraday liquidity. CEF prices change throughout the day and are affected by market conditions. Prices aren’t locked in based on a daily NAV but rather, other secondary-market participants’ willingness to buy and sell shares, similar to a stock. The NAV of the CEF is reported at the end of each trading day. To reiterate, closed-end funds trade more like stocks – driven by supply and demand – while open-end funds trade at the end of each trading day at their NAV.
Beyond trading differences, CEFs can employ different strategies than those employed with open-end funds. For example, CEFs can use leverage or covered calls. This ability to use leverage presents opportunities, but also exposes investors to greater risk. Therefore, it’s crucial that investors do their homework before investing.
Since CEFs have a fixed number of shares, they can invest in less-liquid securities more easily than open-end funds. They can also provide retail investors access to private markets alongside institutional investors, which is unusual in the open-end fund space. And while CEFs can employ these strategies, not all do. This means that the range of options for investors is broader and potentially more attractive. In the CEF market, investors can shop around among a wider selection of investment choices, based on their own individual risk profiles.
Implications for yield
Distributions tend to be higher with CEFs. This can translate to better income streams, which may draw yield-seeking investors' attention. However, keep in mind that the higher the yield doesn't exactly promise a higher total return.
If the yield is high, there is a greater possibility that a fund will have to cut a dividend. The higher the yield, the more likely this will happen. Investors will still need to take a holistic approach, rather than just chasing the highest yield.
In the CEF marketplace, funds with a history of good performance and strong prospects of continued good performance that are trading at a discount have the greatest potential for investors. If the discount narrows after the investment, and the good performance continues, then all the better. With that said, it's imperative that investors consider their risk appetite, and always keep in mind their investment goals, when searching for the funds that suit those needs. Prudent investors must look at more than just discounts and yields.
Time to open the door to CEFs?
In many ways CEFs expose investors to risks not present in connection with open-end funds, however, their structure may make them an attractive alternative when markets start to experience volatility. It's easy to close one's mind to nontraditional solutions. But investors may benefit from assessing their portfolios, goals, and risk profiles when considering opportunities in CEFs.
1 Net asset value (NAV) is the value of an investment fund's assets minus the value of its liabilities.
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund's investment return and principal value will fluctuate so that an investor's shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund's portfolio. There is no assurance that the Fund will achieve its investment objective. Past performance does not guarantee future results.
The use of leverage will also increase market exposure and magnify risk.
Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds'; market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds and mutual funds charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund's gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. Both vehicles seek to deliver returns based on their investment objectives, but neither is FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Standard Investments does not provide tax or legal advice; please consult your tax and/or legal advisor.