Closed-end fund

From Free net encyclopedia

A closed-end fund is a collective investment scheme with a limited number of shares.

In the U.S. legally they are called closed-end companies and form one of three SEC recogonised types of investment company along with mutual funds and unit investment trusts. (Click here for US SEC description of investment company types).

Other examples of close-ended funds are Investment trusts in the UK and Listed investment companies in Australia.

New shares are rarely issued after the fund is launched; shares are not normally redeemable for cash or securities until the fund liquidates. Typically an investor can acquire shares in a closed-end fund is to buy shares on a secondary market from a broker, market maker, or other investor -- as opposed to an open-end fund where all transactions eventually involve the fund company creating new shares on the fly (in exchange for either cash or securities) or redeeming shares (for cash or securities).

The price of a share in a closed-end fund is determined partially by the value of the investments in the fund, and partially by the premium (or discount) placed on it by the market. The total value of all the securities in the fund divided by the number of shares in the fund is called the net asset value, often abbreviated NAV. The market price of a fund share is often higher or lower than the NAV: when the fund's share price is higher than NAV it is said to be selling at a premium; when it is lower, at a discount to the NAV.

Contents

[edit]

Availability

Closed-end funds are typically traded on the major global stock exchanges, in the U.S. the Amex is dominant although the New York Stock Exchange is in competition; in the UK the London Stock Exchange's main market is home to the mainstream funds although AIM supports many small funds expecially the Venture Capital Trusts.

Like their better-known open-ended cousins, closed-end funds are usually sponsored by a funds management company which will control how the money is invested. They begin by soliciting money from investors in an initial offering, which may be public or limited. The investors are given shares corresponding to their initial investment. The fund managers pool the money and purchase securities. What exactly the fund manger can invest in depends on the fund's charter. Some funds invest in stocks, others in bonds, and some in very specific things (for instance, tax-exempt bonds issued by the state of Florida in the USA).

[edit]

Distinguishing features

Some characteristics that distinguish a closed-end fund from an ordinary open-end mutual fund are that:

  1. it's closed to new capital after it begins operating, and
  2. its shares (typically) trade on stock exchanges rather than being redeemed directly by the fund.

Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. Many—if not most—CEFs will raise additional investment capital by issuing preferred shares. In doing so, the fund hopes to earn a higher return with this excess invested capital than what it pays to the new preferred shareholders. Of course, this strategy can backfire, thus detracting from overall returns.

[edit]

Initial offering

Like a company going public, a closed-end fund will have an initial public offering of its shares at which it will sell, say, 10 million shares for $10 each. That will raise $100 million for the fund manager to invest. At that point, however, the fund's 10 million shares will begin to trade on a secondary market, typically the NYSE or the AMEX for American closed-end funds. Any investor who wishes to buy or sell fund shares at that point will have to do so on the secondary market. Except for exceptional circumstances, closed-end funds do not redeem their own shares. Nor, typically, do they sell more shares after the IPO (although they may issue preferred stock, in essence taking out a loan secured by the portfolio).

[edit]

Exchange traded

Closed-end fund shares trade continually at whatever price the market will support. They also qualify for advanced types of orders such as limit orders and stop orders. This is in contrast to open-end funds which are only available for buying and selling at the close of business each day, at the calculated NAV, and for which orders must be placed in advance, before the NAV is known. Some funds require that orders be placed hours or days in advance.

As a secondary effect of being exchange-traded, the price of CEFs can vary from the NAV. In particular, fund shares often trade at what look to be really irrational prices because secondary market prices are often very much out of line with underlying portfolio values.

[edit]

Discount

For instance, US closed-end stock funds have share prices that are typically about 10% less than per-share portfolio values. That is, if a fund has 10 million shares outstanding and if its portfolio is worth $200 million, then each share should be worth $20 and you would expect that the market price of the fund's shares on the secondary market would be around $20. But, very oddly, that's typically not the case. The shares may trade for only $18 or even only $16. In the former case, the fund would be said to be "trading at a 10% discount to Net Asset Value," where Net Asset Value (NAV) is simply the fund's total assets minues total liabilities. In the latter case, the fund would be said to be trading at a 20% discount to NAV.

[edit]

Premium

Even stranger, funds very often trade at a substantial premium to NAV. Some of these premia are extreme, with premia of several hundred percent having been seen on occasion. Why anyone would pay $30 per share for a fund whose portfolio value per share is only $10 is not well understood, although irrational exuberance has been mentioned. One theory is that if the fund has a strong track record of performance, investors may speculate that the outperformance is due to good investment choices by the fund managers and that the fund managers will continue to make good choices in the future. Thus the premium represents the ability to instantly participate in the fruits of the fund manager's decisions.

The presence of discounts is also puzzling since if a fund is trading at a discount, theoretically a well-capitalized investor could come along and buy up all the fund's shares at the discounted price in order to gain control of the portfolio and force the fund managers to liquidate it at its (higher) market value (although in reality, liquidity concerns make this impossible since the Bid/offer spread will drastically widen as fewer and fewer shares are available in the market). Benjamin Graham claimed that an investor can hardly go wrong by buying such a fund with a 15% discount. However, the opposing view is that the fund may not liquidate in your timeframe and you may be forced to sell at an even worse discount, or the investments in the fund may lose value.

A great deal of academic ink has been spent trying to explain why closed-end fund share prices aren't forced by arbitrageurs to be equal to underlying portfolio values. Though there are many strong opinions, the jury is still out. It is easier to understand in cases where the CEF is able to pick and choose assets and arbitrageurs are not able to determine the specific assets until months later, but some funds are forced to replicate a specific index and still trade at a discount.

[edit]

Comparison with open-ended funds

With open-ended funds, the value is precisely equal to the NAV. So investing $1000 into the fund means buying shares that lay claim to $1000 worth of underlying assets (apart from sales charges). But buying a closed-end fund trading at a premium might mean buying $900 worth of assets for $1000.

Some advantages of closed-end funds over their open-ended cousins are financial. CEFs' fees are usually much lower (since they don't have to deal with the expense of creating and redeeming shares), and they need not worry about market fluctuations to maintain their "performance record". So if a stock drops irrationally, the closed-end fund may snap up a bargain, while open-ended funds might sell too early.

Also, if there is a market panic, investors may sell en masse. Faced with a wave of sell orders and needing to raise money for redemptions, the manager of an open-ended fund may be forced to sell stocks he'd rather keep, and keep stocks he'd rather sell, due to liquidity concerns (selling too much of any one stock causes the price to drop disproportionately). Thus all it may have left are the dud stocks that no one wants to buy. But an investor pulling out of a closed-end fund must sell it on the market to another buyer, so the manager need not sell any of the underlying stock. The CEF's price will likely drop more than the market does (severely punishing those who sell during the panic), but it is more likely to make a recovery when the intrinsically sound stocks rebound.

Because a closed-end fund is on the market, it must obey certain rules, such as filing reports with the listing authority and holding annual stockholder meetings. Thus stockholders can more easily find out about their fund and engage in shareholder activism, such as protest against poor management. [1]

[edit]

Examples

Among the biggest, long-running CEFs are:

  • Foreign & Colonial Investment Trust plc (LSE:FRCL)
  • Witan Investment Trust plc (LSE:WTAN)
  • Tri-Continental Corporation (NYSE:TY)
  • Gabelli Equity Trust (NYSE:GAB)
  • Salomon Brothers Fund (NYSE:SBF)
[edit]

See also

[edit]

External links

Retrieved from "http://www.netipedia.com/index.php/Closed-end_fund"