What is a closed-end fund?
A closed-end fund (“CEF”) is a type of investment company that pools money from investors for the purpose
of investing in stocks, bonds, and/or other assets. Each CEF has its own specific set of investment
objectives and policies.
CEFs are regulated by the Securities and Exchange Commission (“SEC”) and primarily governed under the rules of the Investment Company Act of 1940.
How are CEFs created?
The underlying assets of a CEF are raised in an initial public offering (“IPO”). This means the fund’s
capital is semi-permanent and not subject to regular investor deposits or withdrawals. Following the
IPO, investors may buy or sell shares in the fund from other investors at a price established in the
secondary market with no impact to the fund’s investments or its underlying net asset value (”NAV”).
This semi-permanent capital enables CEF managers to avoid forced selling or buying of individual security holdings due to fund flows, allowing them to stay focused on the fund’s long-term investment strategy.
How do CEFs use leverage?
CEFs are permitted to borrow capital, subject to regulatory limits, to increase investment exposure and enhance the income and capital appreciation potential of the fund. However, the use of leverage also may increase the level of market risk and the price volatility of the shares.
How does a CEF differ from a mutual fund or an exchange traded fund (“ETF”)?
CEFs, like mutual funds, are managed portfolios offering investors the opportunity to allocate to specific themes, sectors, or asset classes. Unlike mutual funds, which issue or redeem shares on a daily basis at NAV, following their initial CEF’s IPO, CEF shares are generally not created or redeemed, but trade on a stock exchange at a price that reflects the demand for such shares, which may be greater or less than its NAV. A CEF is also permitted to issue debt and preferred shares, unlike mutual funds.
ETFs, like CEFs, offer investors intraday pricing and trade on a stock exchange in the secondary market. Unlike CEFs, ETFs adjust for market demand through the creation and redemption of shares as needed, reducing the effect such demand has on the ETF’s trading price as compared to a CEF. However, ETF managers account for these fund flows in their management of the portfolio. Accordingly, many ETFs are passive investment vehicles that track a specific index with daily of portfolio holdings disclosure. CEFs are typically managed portfolios not tied to an index, with monthly or quarterly holdings disclosures. CEFs also have more flexibility to invest in less-liquid investments as compared to both mutual funds and ETFs.
What does a premium or discount to net asset value (NAV) mean?
CEFs can trade at either a premium or a discount to their NAV. The NAV price represents the current aggregate value of a fund’s portfolio at a given time divided by the shares outstanding. If a CEF is trading in the secondary market at a price higher than the current NAV per share, the CEF is trading at a premium to NAV. If a CEF is trading in the secondary market at a price lower than the current NAV per share, the CEF is trading at a discount to NAV. The level of premium or discount will usually change on a daily basis due to changes in the market demand for the CEF and the underlying securities held in the CEF’s portfolio.
Can CEFs issue additional shares after the initial public offering (“IPO”)?
A CEF can issue additional shares after its IPO to fund investment opportunities primarily through two
methods: a rights offering and/or an at-the-market (“ATM”) program. A rights offering is an offer to
existing shareholders to purchase additional new shares of the CEF at a future date, usually at a discount
to the fund’s market price. The offering allows fund shareholders an opportunity to increase their
investment in the fund at a discounted price, while providing immediate new capital for the fund’s
managers to deploy.
An ATM program is another method whereby a CEF can issue additional shares after its IPO. In an ATM program, the fund sells new shares into the public market each day the fund trades at a premium to its NAV. In this program, the fund engages an investment bank to sell newly issued shares during secondary market trading, with the intent of having minimal market impact. ATM transactions are generally accretive to current shareholders and provide continuous new capital for the fund’s managers to deploy.
How are CEF distributions treated for tax purposes?
Similar to open-end mutual funds and ETFs, CEFs are required by law to pass on to shareholders 90% or more
of its net investment income and 98% or more of net realized capital gains. Shareholders of a CEF
receive a Form 1099-DIV early in each calendar year which categorizes the dollar amount of distributions
made in the previous year for tax purposes.
Distributions will generally be categorized as originating from one or more of the following sources: (1) interest payments from fixed income securities; (2) dividend income from common stocks; (3) realized capital gains (long-term and short-term) and, (4) return of capital.
What is meant by return of capital?
A return of capital consists of shareholders’ initial principal plus portfolio appreciation that has not yet been realized as a capital gain. CEFs are required to designate the portion of the distributions made in a given tax year as return of capital if they have not generated sufficient funds from interest income, dividend income, or realized capital gains to meet the actual distributions made to shareholders.
What is meant by managed distributions?
Some CEFs have received approval from the SEC to employ a managed distribution program which is designed to facilitate consistent and predictable distributions to shareholders, often with the intent to be more closely aligned with the CEF’s estimated total return over time. For CEFs that generate both income and capital appreciation, the managed distribution program provides an alternative to the payment of a single capital gain distribution in December, typical of many equity mutual funds and CEFs without a managed distribution program.
What are some of the primary risks associated with investing in CEFs?
Investors should be aware of the many risks associated with any investment product, including CEFs. The market price of a CEF at any point in time is likely to vary from the fund’s NAV and this variance could have a significant impact on an investor’s return over time. CEFs and their underlying assets are subject to market movements and volatility, which can be magnified for CEFs that utilize leverage. Additionally, the risks associated with a CEF’s underlying portfolio holdings will apply, which may include risks of less liquid asset classes. A more thorough discussion of the specific risks associated with CEFs can be found in the prospectus of each fund.
Where can I find additional information about CEFs?
The following websites contain additional information about closed-end funds:
Open-end mutual funds, closed-end funds and exchange-traded funds are different types of investment vehicles with different expense structures and different inflows/outflows and distribution requirements. The information provided within is not a comprehensive list of differences between the product types.
Closed-end funds may trade at a discount from net asset value. When sold, shares may be worth more or less than the purchase price or the net asset value. It is important to consider the objectives, risks, charges and expenses of any fund before investing. For this and other information that should be read carefully, please view prospectus or other current fund information provided by the fund’s sponsor.
A closed-end fund’s use of leverage creates the possibility of higher volatility for the fund’s NAV, market price, distributions and returns. There is no assurance that a fund’s leveraging strategy will be successful.
There are risks inherent in any investment including, but not limited to, interest rate risk, credit risk, market risk and the possible loss of principal. Past performance is no guarantee of future results.
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