Most investors are well acquainted with the most popular types of pooled investment accounts: mutual funds and exchange-traded funds or ETFs. Yet a much smaller corner of the fund universe is even older and substantially less well understood: closed end funds. This niche of the investment company space offers some unique opportunities for informed investors, especially in providing consistent income. However, their unique construction can also present added risk to which one must be attuned.
The earliest investment pools available to individuals were essentially closed end funds. In 1893, investors were offered shares in the Boston Personal Property Trust, the earliest example of a US fund and modeled on British investment trusts of the 17th century. 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.
Yet despite their attractive features, they remain relatively undiscovered. At just $279 billion in assets as of 2020, closed end funds make up less than 1% of the $30 trillion in total US fund assets. And while mutual fund and ETF assets have more than doubled over the past decade, CEF assets have remained essentially stable. Roughly two thirds of all CEFs are bond funds, the bulk of which are municipal bonds.
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, which means that by definition the market value is equal to the sum of the underlying asset values.
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 like the NYSE or the NASDAQ. This structure 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. Usually, CEFs trade at a discount to the NAV, although at times they may sell at a premium in excess to the underlying value. Note also that over time discounts and premia vary quite extensively depending on a variety of underlying conditions.
Secondly, CEFs are allowed to utilize borrowed money or leverage to enhance potential returns. This is done to magnify the cash flow yield on fixed income funds or capital gains in equity funds. However, like all forms of leverage, amplification works both ways, meaning losses in the underlying securities are also multiplied. Leveraged CEFs exhibit more volatility than the actual holdings in the fund or in comparable unleveraged competitors.
Despite the addition risk of employing leverage, closed end funds have an admirable track record of producing positive absolute returns relative to unleveraged funds of comparable holdings. An analysis conducted by fund sponsor Nuveen found that between 1989 and 2019, a hypothetical municipal bond CEF portfolio employing leverage added an average 1.8% total return each year over the unleveraged equivalent. The analysis also estimated that leverage enhanced returns in 96.7% of all rolling 3-year time periods. A similar report from Blackrock showed that leveraged municipal CEFs outperformed the unleveraged equivalent in 15 of the past 20 years.
So, what's not to like? Well as with most investments, "caveat emptor" obtains. Closed end funds are complex, and investors need to understand the implications of leverage as well as the discount or premium before diving in. More about which next week.
Christopher A. Hopkins is a chartered financial analyst in Chattanooga.