Current Thinking

Pros and Cons of Closed-End Funds

A blog by Frederic Slade, CFA, Assistant Vice President and Senior Director, Investments, Pentegra Retirement Services – December 13, 2016

A closed-end fund (CEF) is a publicly-traded, managed investment vehicle regulated by the Securities and Exchange Commission (SEC). An open-end fund is also professionally managed and regulated. Two types of open-end funds are mutual funds and exchange-traded funds (ETFs). An ETF is organized like a mutual fund but trades like a stock. Both open-end funds and CEFs charge an expense ratio to investors. In addition, both open-end funds and CEFs pass through income and capital gains to shareholders for tax purposes. However, CEFs have a fixed number of shares outstanding based on an Initial Public Offering (IPO), while mutual funds continuously offer shares to investors and stand ready to redeem shares at all times.

The first CEFs were offered in 1893. According to the Investment Company Institute, there were 558 CEFs at the end of 2015, holding $261 billion in assets. Over 60% of CEF assets were in bond funds. CEFs are more similar to ETFs than to mutual funds. Both CEFs and ETFs trade throughout the day and both are continuously priced during the trading day like stocks. This differs from mutual fund pricing, where the Net Asset Value (NAV) is calculated at the end of each business day and is used for buy/sell transactions. The price of both ETFs and CEFs is based upon the price at which investors are willing to buy and sell (i.e. supply and demand). This means that both ETFs and CEFs can trade at a premium or discount to their NAVs. Most CEFs currently trade at a discount. In fact, of 30 general equity CEFs tracked by Lipper as of August 26, 2016, 28 were trading at a discount to NAV.

However, there are several differences between ETFs and CEFs. An ETF is generally passively managed and its price tends to closely track the underlying value of its holdings under normal market conditions. This means that its price tends to be close to its NAV. A CEF is actively managed and its price can have a significant variance to its NAV. A CEF will also trade at a discount or premium to its NAV not only because of the value of its underlying portfolio but due to investor sentiment- i.e., a certain sector may be in favor, or a fund manager may be highly (or not well) regarded. Another important difference is the use of leverage, whereby a fund seeks to use various financial instruments or borrowed capital to amplify its returns. Although both CEFs and ETFs can use leverage (debt, preferred stock, with up to 33% leverage for CEFs), most CEFs include leverage, whereas investors can choose between leveraged and non-leveraged ETFs. Fees also tend to be higher for CEFs: all-in expense ratios tend to be 0.60% or higher while ETF expense ratios tend to be in the 0.10%-0.20% range.

How have CEFs performed? The returns and risks of CEFs are based on several factors, including the underlying portfolio, level of discount/premium to NAV, fees and leverage.

The following are returns for the S-Network Closed End Funds Index, and a 50%/50% mix of stocks (S&P 500 Index) and bonds (Barclays Capital US Aggregate Bond Index):

The above returns show mixed results for CEFs when compared with a passive 50/50 stock/bond mix. CEF returns relative to the markets have been higher in the short term, but lower over longer time periods. It is also worth noting that CEFs have an annual standard deviation of returns of over 11% despite a significant percentage of assets in bonds.

What about investing in CEFs versus ETFs? Though recent price discounts and high yields for CEFs have been enticing, there are risks to consider. CEF leverage, while creating potential for higher yields, can create unexpected volatility, depending upon interest rates and market conditions. CEFs can trade at a significant discount or premium at any time, which can impact return volatility. Also, since CEF managers are not subject to daily cash outflows, this allows the fund to invest in less liquid securities-which in itself may create more investor risk.

In summary, given their complexity and cost, CEFs may be more appropriate to consider for a long-term institutional investor as opposed to a retail investor. The retail investor may be better off considering non-leveraged ETFs or mutual funds.

NOTE: Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Past performance is not a guarantee of future results.