As with traditional open-end mutual funds, closed end funds offer investors the opportunity to own a basket of securities like stocks and bonds. But due to their somewhat unique structure, CEFs are more complex and require a deeper understanding before being added to a portfolio. The behavior of these funds depends upon more than just the performance of the securities within.
Some of the very first investment pools available to individuals were closed end funds. British investment trusts became popular in the early 1860s in the financing of American railroads. In 1893, investors were offered shares in the Boston Personal Property Trust, the earliest example of a US fund. By the time of the Great Depression, investment trusts dominated the landscape and in fact played a seminal role in the stock market crash of 1929, thanks to extreme valuations and excessive margin debt. Regulatory actions in the 1940s addressed some of the riskier aspects of CEFs to make them more suitable for individual investors.
Following the great crash, interest in investment trusts or closed-end funds waned but has resurged in recent years, particularly as low interest rates have prodded investors to seek higher yields.
Two factors make closed-end funds different and more complicated than other types of funds: their fixed-share construction and the use of leverage.
Traditional mutual funds are called "open-end" funds, since the number of shares changes daily as money flows into or out of the funds. Each business day, closing prices of all the funds' holdings are tallied to determine the Net Asset Value (NAV). This price is reported daily to fund holders, and is the price received for selling shares or paid for purchasing them. Net inflows of cash purchase newly created shares, while redemptions trigger extinguishment of existing shares at the NAV. This is by far the biggest segment of the fund market, with approximately $16 trillion in assets in the US.
Closed-end funds get their name from the fact that a fixed number of shares are created at inception, and rarely are added to or annihilated. Also, unlike open-end funds whose shares reside at the fund companies, CEFs trade on stock exchanges (mostly on the NYSE). This structure usually leads to an imbalance between the value of the underlying securities (the fund's NAV) and the market price of the fund shares on the exchange. At present, the average closed-end fund trades at about an 8 percent discount to its underlying NAV. During the lead-up to the crash of 1929, premiums over the NAV ran into the 50 percent range.
Secondly, CEFs are allowed to utilize borrowed money or leverage to enhance potential returns. This is typically done to juice up the cash flow yield on fixed income funds. However, like all forms of leverage, amplification works both ways and losses in the underlying securities are multiplied. Leveraged CEFs can exhibit more volatility than the holdings in the fund or comparable unleveraged competitors.
Closed-end funds still represent a niche market, holding just under $300 billion, around 60 percent of which is in bond funds held for income. Still, many individual investors own these instruments without a full understanding of their properties and risks. Next week we will explore some popular examples and evaluate their risks.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.