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Portfolio > Mutual Funds

Time to Open Up to Closed-End Funds?

By Josh Duitz

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While traditional, open-end mutual funds have served many investors well, it may be high time to open up to closed-end funds. Despite several similarities, there are nuances that distinguish the two, and may make closed-end funds a nice complement to a more traditional fund lineup.

The most basic difference between closed-end funds and traditional, open-end funds is the number of shares the funds hold. Closed-end funds issue a set amount of shares upon inception, unlike mutual funds, which can issue an unlimited number of shares over time.

This core structural difference means that closed-end funds trade and function differently than their open-end counterparts. These operational differences have implications for fund managers, not to mention investor portfolios.

Because closed-end fund shares trade on the secondary market, investors can purchase shares at a discount, which may be advantageous. While this gives closed-end funds a distinct advantage over open-end funds, there is another side of the coin. Investors may also purchase closed-end fund shares at a premium, which could be disadvantageous.

It’s not as simple as this, however. Even if investors purchase closed-end fund shares at a discount, it’s possible that, over time, this discount could widen. Conversely, while investors who have purchased closed-end fund shares at a premium seem to be at a disadvantage, there is 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, in the short term, investors have the opportunity to search for good funds trading at a discount.

The level of liquidity differs between closed-end and open-end mutual funds, as well. Open-end funds have daily liquidity. Their net-asset value (NAV) is calculated at the end of the day, when the market closes. Shares are redeemed at NAV. Closed-end funds, on the other hand, have the advantage of intraday liquidity.

Closed-end fund prices vary depending on market conditions when the investor chooses to sell or buy shares. Investors, therefore, must consider their risk tolerance before choosing closed-end funds.

Beyond trading differences, closed-end funds can employ different strategies than open-end funds. Closed-end funds, for example, can use leverage or covered calls. While closed-end funds’ ability to use leverage presents opportunities, it also exposes investors to greater risk, so it’s crucial that they do their homework before investing.

While closed-end funds can employ these strategies, not all do. This means that the range of options for investors is broader and potentially more attractive. In the closed-end fund market, investors can shop around among a broader selection of investment choices, based on their own individual risk profiles.

Because of these strategic differences, distributions tend to be higher with closed-end funds. This can translate to better income streams, which may draw yield-seeking investors’ attention. However, higher yield doesn’t promise 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. So investors will still need to take a holistic approach, rather than just chase the highest yield, to enjoy comfortable returns.

In the closed-end fund marketplace, funds with a history of good performance and strong prospects of continued good performance, trading at a discount, have the greatest potential for investors. This potential is greatest if the discount narrows after the investment, and the good performance continues.

But, of course, investors need to consider their risk appetite and investment goals and find the funds that suit those needs. Prudent investors must look at more than just discounts and yields.

To investment professionals and those familiar with closed-end funds, these differences may be common knowledge. But what we think many investors might overlook is how the closed-end fund structure may free managers from the demands of the market.

With closed-end funds, managers don’t have to worry about inflows and outflows as they do with traditional open-end funds. Because of the closed-end structure and its predetermined number of shares, there is a fixed pool of capital. Therefore, the market doesn’t force the buying and selling of closed-end fund shares as it does with open-end funds.

For example, if markets start dipping, 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, closed-end fund managers would be more capable of staying the course, as their capital pool is fixed.

Furthermore, when managers are forced to sell stocks, there may be capital gains. Because closed-end fund 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.

So, while in some ways closed-end funds do open up the possibility of different risk than their open-end counterparts, 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 and considering opportunities in closed-end funds.

Josh Duitz is a senior vice president on the Global Equities team at Aberdeen Standard Investments, where he manages the Aberdeen Total Dynamic Dividend Fund.  

 

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