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What is a closed-end fund?

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Even though they have been traded in the U.S. for over a century, closed-end funds (CEFs) are not well understood.  A common misunderstanding is that a closed-end fund is a type of traditional mutual fund or an exchange-traded fund (ETF). A closed-end fund is NOT a traditional mutual fund that is closed to new investors.

At its most fundamental level, a CEF is an investment structure (not an asset class), organized under the regulations of the Investment Company Act of 1940. A CEF is a type of investment company whose shares are traded on the open market, like a stock or an ETF.

Why are they called "closed-end" funds?

Like a traditional mutual fund, a CEF invests in a portfolio of securities and is managed, typically, by an investment management firm.  But unlike mutual funds, CEFs are closed in the sense that capital does not regularly flow into them when investors buy shares, and it does not flow out when investors sell shares.  After the initial public offering, shares are not traded directly with the sponsoring fund family, as is the case with open-end mutual funds.

Instead, shares are traded on an exchange, typically, and other market participants act as the corresponding buyers or sellers.  The fund itself does not issue or redeem shares daily. Like stocks, CEFs hold an initial public offering at their launch. With the capital raised during this IPO, the portfolio managers then buy securities befitting the fund's investment strategy.

After the IPO, there are only five ways to increase capital within the portfolio:

  1. Making sound investment choices that appreciate and thus increase the net asset value
  2. Issuing debt, thereby leveraging the fund
  3. Issuing preferred shares, thereby leveraging the fund
  4. Conducting a secondary share offering (selling new shares to the public)
  5. Conducting a rights offering (giving existing shareholders the right to invest more capital into the fund in proportion to their existing ownership)

Similarly, there are only five ways capital can flow out of a CEF:

  1. Distributions to shareholders
  2. Poor investment decisions
  3. A tender offer to repurchase shares, which is a method to control discounts
  4. For leveraged funds only, forced sales to remain in compliance of leverage limits
  5. The liquidation of the fund

So, because capital does not flow freely into and out of CEFs, they are referred to as "closed-end" funds.

The "closed-end" structure gives rise to discounts and premiums. After the IPO, a CEF's shares trade on the open market, typically on an exchange, and the market itself determines the share price.  The result is that the share price typically does not match the net asset value of the fund's underlying holdings. (Net asset value = (Fund Assets-Fund Liabilities)/Shares Outstanding)

If the share price is higher than the net asset value, shares are said to be trading at a "premium."  This is typically portrayed as a "positive discount," although mathematically that is counterintuitive. For instance, a fund trading at a two percent premium would be shown as "+2%."  If the share price is less than the net asset value, the shares are said to be trading at a "discount."  This is typically portrayed with a minus sign, "-2%."

The closed-end structure has other implications, as well:

  1. Unlike with open-end mutual funds, a closed-end fund manager does not face reinvestment risk from daily share issuance
  2. A closed-end fund manager does not have to hold excess cash to meet redemptions
  3. Because there is no need to raise cash quickly to meet unexpected redemptions, the capital is considered to be more stable than in open-end funds. It is a stable capital base

The relatively stable capital base, in turn, gives rise to two other attributes:

First, it makes CEFs a good structure for investing in illiquid securities, such as emerging-markets stocks, municipal bonds, timberland, etc. The higher risk involved with investing in illiquid securities could translate into higher returns to shareholders.

Second, regulators allow the funds to issue debt and preferred shares, with strict limits on leverage. The fund can issue debt in an amount up to 50% of its net assets.  Another way to look at this is that for every $1 of debt, the fund must have $3 of assets (including the assets from the debt).  This is commonly referred to as a 33% leverage limit.

The fund can issue preferred shares in an amount up to 100% of its net assets. Another way to look at this is that for every $1 of preferred shares issued, the fund must have $2 of assets (including the assets from the preferred shares). This is commonly referred to as a 50% leverage limit.

The point is that CEFs are not highly leveraged, though any amount of leverage magnifies the volatility of the fund's net asset value.

Learn how to access Fidelity's Closed End Fund Screener

Key takeaways:

  1. CEFs are a unique investment vehicle, combining elements of equities and mutual funds.
  2. Capital does not flow into or out of the funds when shareholders buy or sell shares.
  3. Shares are traded on the open market.
  4. A CEF's share price is almost always different from its net asset value.
  5. Investors need to be aware of the resulting premium or discount.
  6. Because of the stable asset base, CEFs can invest in illiquid securities and can issue debt and/or preferred shares.
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©2012 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.
Article copyright 2012 by Morningstar, Inc. Reprinted with permission from Morningstar, Inc. The statements and opinions expressed in this article are those of the author. Fidelity Investments cannot guarantee the accuracy or completeness of any statements or data.

Closed end funds may trade at a discount (or premium) to their NAV and are subject to the market fluctuations of their underlying investments. Shares of closed end funds frequently trade at a market price that is a discount to their NAV. Closed end funds are subject to management fees and other expenses.

The Closed End Fund Screener may include closed end funds not registered under the Investment Company Act of 1940

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