Understanding the Ins and Outs of Closed-End Funds

January 8, 2022

Nearly 4 million US households were invested in closed-end funds at the end of 2020. Total closed-end fund assets represented $279 billion managed by 91 fund sponsors, according to data from the Investment Company Institute. This is a growing part of the investment world.

The majority of closed-end funds are bond funds, which make up 62% of total closed-end fund assets, a portion that has remained relatively stable over the years. Closed-end funds can also invest in stocks. But the most interesting thing about them is the way they are structured rather than simply what they can invest in.

How are closed-end funds structured?

A closed-end fund is a type of publicly-traded vehicle that issues a fixed number of common stock through an initial public offering. While these shares can be traded on an exchange based on supply and demand, the manager cannot issue new shares to create new inflows of cash into the fund.

Just like a traded corporation, a closed-end fund can sell preferred equity and issue debt to leverage the portfolio by allowing the fund to purchase more underlying assets with the goal to boost returns. However, leverage also increases risk. Closed-end funds had $50.6 billion outstanding in preferred shares and leverage at the end of 2020.

Closed-end funds are typically actively managed, meaning that they charge higher management fees than open-end funds, but also that returns are expected to be higher. They are traded on an exchange.

While some mutual funds are closed-end funds, the majority are open-end funds, which can sell as many shares as investors want. Closed-end funds can focus on a country, a sector or build a broader global portfolio such as international funds.

What are some of the advantages and drawbacks of closed-end funds?

There are pros and cons to closed-end funds. One of their main advantages is that due to their unique structure, investors in closed-end funds can purchase exposure to specific securities at a discount if a fund is worth less than its portfolio’s value. They can also trade at a premium, allowing the possibility to book a profit on a sale. Closed-end funds tend to have longer hold periods and are less sensitive to short-term volatility, and closed-end funds also provide attractive income through monthly distributions.

However, a heavy discount can also be a drawback, making it challenging to sell shares on the secondary market at an attractive price. Closed-end funds can also be opaque and have hidden risks, especially if the manager uses leverage. Investors should be able to analyze carefully the capital structure of the fund and understand how the leverage is used, and how it affects volatility. Because they are traded on secondary markets, investors need a brokerage account to buy and sell shares in closed-end funds, which can be a drawback for some investors, but overall closed-end funds can present attractive investment opportunities.

What about closed-end funds in private markets?

Closed-end funds can also be found in private markets, but they differ slightly from the ones traded on exchanges. In the world of alternative investments, closed-end funds also have the particularity of keeping the size of a vehicle untouched once the fundraise has been completed. Investors in a private equity or venture capital fund, called limited partners because they invest in the partnership, can also trade their stakes on the secondary market, but that market is less liquid and not automated.

One big difference is that a private equity closed-end fund has a specific lifespan, typically 10 years, which may be extended by two or three years with the consent of limited partners. Another is the fact that private closed-end funds typically have minimum investment levels that are high, which can make private equity and other private markets investments difficult to access for individual investors.

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