Closed end funds are “packaged products” like mutual funds and ETFs in that they hold other investments like individual stocks and bonds. Like mutual funds and ETFs, closed end funds can be categorized by Morningstar categories, helping to gain insights into the type of strategy the closed end fund is. Most closed end funds are actively managed rather than passively managed to mimic a particular index (S&P 500, etc.).
Closed end funds trade on financial exchanges throughout the day, similar to ETFs. This allows investors to be able to buy and sell a closed end fund anytime during the trading day. Since closed end funds trade intra-day, there is a bid-ask spread, similar to ETFs. This is different than mutual funds, which trade once at the end of the trading day at the fund’s Net Asset Value.
Two of the biggest factors that provide interesting characteristics of closed end funds relative to mutual funds and ETFs, is that 1) they often trade at wide premiums and discounts and 2) they often utilize leverage to increase returns (usually to generate higher income).
Closed End Fund Premiums/Discounts
Closed end funds are created through an initial public offering (IPO) to gather cash to invest in a portflio of securities. The value of the securities in the portfolio that trade every day is the closed end fund’s Net Asset Value (NAV). The NAV’s value is the value of the underlying assets in the fund. If you remember, ETF providers often attempt to keep the premium/discount of the ETF’s trade price close to the ETF’s underlying investments and its NAV. What’s very different about closed end funds is that closed end fund providers do not actively manage the premium/discount of the closed end fund or try to keep the closed end fund trading price close to the closed end fund’s NAV. This is both a risk and and opportunity.
If the closed end fund provider is not trying to keep the premium/discount to NAV tight to the trading price, that means the premium/discount can be wide. The premium/discount for a closed end fund is driven by the demand (investors buying) and supply (investors selling) for the closed end fund.
Thoughtful investors in closed end funds would be able to take advantage of a closed end fund trading at a discount to NAV (less than what the value of the investments are worth). If the value of the closed end fund’s investments in the fund is $100/share, but the share price of the closed end fund is $90, then the investor buying the closed end fund is getting a 10% discount on the assets. On the flip side, if the share price is trading at $110, a premium to NAV, then the investor is overpaying for the closed end fund’s investments in the fund. That doesn’t make much sense, does it?
In the closed end fund space, trading volumes aren’t as strong and liquid as ETFs or mutual fund. For this reason, the closed end fund’s share prices can vary wildly, particularly in volatile markets. This is important: when financial markets sell off quickly and deeply, and there is a lot of fear in the market and investors are blindly selling everything for whatever reason, discounts in closed end funds can widen significantly.
Here’s an example. A closed end fund could historically trade at NAV over time (no premium or discount), on average. Then let’s say in a big risk off market,the closed end fund’s investments may fall 20% and investors in the fund get scared, and start aggressively selling the closed end fund. Since the fund doesn’t have a lot of trading volume, the investors’ aggressively selling the fund pushes the discount to NAV from a 3% discount to a 20% discount. Adding the 20% decline in the investments and an additonal 20% of the price going from no discount to a 20% discount, that’s a 40% selloff in the closed end fund. For holders of the closed end fund, that’s a short-term problem as they are down 40%. For those investors not in the closed end fund, can now take advantage of a potential buying opportunity in the fund!
So as an investor looking for a buying opportunity in closed end funds after a major selloff, you can buy the closed end fund that just declined in value and due to a widening discount to NAV. The new investor can essentially buy the closed end fund at a 20% discount to NAV, getting it 20% cheaper than what the underlying investments are worth. Everyone likes a discount, right? I sure do!
Now, let’s say the financial markets are stabilizing a bit, but not yet rallying strongly following the recent selloff. Now, other investors looking for opportunities are trying to find bargains. They find the closed end fund trading at a 20% discount, find it attractive, and demand increases for the closed end fund. Since the trading volume is low (less liquid), the newly found strong demand for the fund starts to push the closed end fund share price up, reducing the available discount from 20% (cheap) back to flat or even to NAV (no premium or discount). So investors that bought the closed end fund at a substantial discount, made money when the discount closed.
Now, let’s say the financial markets are starting to rally strongly and the NAV of the fund starts to move higher, back to its old highs. So the investor that bought the closed end fund at a 20% discount, got the return from the 20% discount tightening, plus the return of the closed end fund’s NAV rising back to its old highs. That’s an over 40% return, just by taking advantage of both discounts and investment selling off and returning back to “normal”. Buy low. Sell high.
Closed end funds that trade at a premium to NAV, should be considered higher risk options. A closed end fund that is trading at a premium to its NAV indicates that ivnestors are paying more for the underlying assets. This can happen when uneducated investors are attracted to historical performance, or higher yields, or just have no idea what they are doing. Just be careful with closed end funds trading at a premium.
Here’s a quick example. Let’s say an investor unknowingly buys shares in a closed end fund trading at a 10% premium to NAV. Then the fund’s NAV rallies 10%, but the premium goes from 10% to flat to NAV. In this scenario, even though the investor was correct that the underlying assets in the fund (the fund’s NAV) would rally, since the premium fell from 10% to flat to NAV (declined 10%), the investor would not have made any money. This is due to the NAV increasing 10% and the 10% premium declining to 0% = flat performance.
Just remember, with closed end funds, the price performance is equal to the change in the fund’s NAV plus the change in the fund’s premium and discount to NAV. Buying cloesd end funds with large discounts and avoiding those with high premiums may be a suitable option to consider for most.
Leverage in Closed End Funds
Another characteristic of closed end funds that investors like is the utilization of leverage in some closed end funds. Based on their structures, closed end fund portfolio managers can borrow money and create leverage to invest more into their investments for a higher potential price/income return. They do so by borrowing at a lower cost (say 2%) and investing in things that they think can make more than (say 5%) the cost of the amount borrowed. This leveraged spread is what makes closed end funds enticing for investors.
Leverage goes both ways and can be a big negative in certain market environments, particularly in big market selloffs. In deep market selloffs, portfolio managers that have leverage in their portfolios may get margin calls, meaning they need to raise cash to cover their investments. If they don’t have added sources of liquidity to cover the margin calls, they need to sell securities in a down market (not usually a great idea) or tap a line of credit (if available). Closed end funds also generally have leverage ratios they need to maintain. If the leverage (borrowing) gets to high relative to the underlying leveraged assets, the ratio between the two called a leverage ratio, the fund manager may need to reduce their leverage, again at the wrong time after the market sold off. You want a manager to buy more ivnestments and add more leverage after a market sells off, not sell and reduce leverage.
I have seen this negative leverage feedback loop happen, particularly in highly volaile closed end funds tied to the energy market in 2020. When oil futures fell to a -$37 per barrel (yes negative!), energy/oil related stocks crashed. This forced a lot of leveraged energy-related closed end funds to try to support their funds, including tapping lines of credit. As the energy investments sold off, the fund’s leverage ratios spiked, forcing closed end fund portfolio managers to reduce leverage in the fund at the exact wrong time. So at the bottom of the market, the closed end funds were at much less risk levels than when they where before the big market selloff. So when the rebound in energy stocks happened, the closed end funds did not fully recouperate the losses because they locked in losses being the most defensive at the bottom of the market. For those investors that rode the closed end fund down to the bottom, they didn’t get the rebound they hoped for.
Leverage can be a positive and a negative depending on the market enviornment. Investors that are cognizant of the upside and downside potential of the leverage in closed end funds can appropriately take advantage. Just be patient and the market will come to you. It is riskier to chase or be overly leveraged in a strong market that has the potential to reverse. Consider waiting for the deep selloff, then re-evaluate investing in a leveraged closed end fund.
Distributions
Closed end funds are often used for investors seekign higher income generating strategies. Many closed end funds are income-focused. The added leverage and potential for funds trading at decent discounts to NAV results in distribution yields that can be above other similar mutual funds or ETFs.
One thing to look out for is for those closed end funds with a managed distribution policy. Some funds will set an annualized distribution target yield of say, 5%, that they will pay out throughout the year (monthly, quarterly, etc.). If a fund is only generating a yield of 3% on their investments, the fund has to come up with the other 2% to get to their target 5% yield. To do so, they will often sell some of their investments and distribute the cash to make of that 2% difference. This selling of investments and distributing the cash to meet a managed distribution policy is called a “Return of Capital”.
Unknowning investors may be attracted to a high yielding closed end fund, but not realize that only 3% of it is real income from investments, and the other 2% is just a return of their capital by selling investments. Investors should make sure they know how much of the fund’s distribution is actually income that they want versus a return of capital that they may not want. Closed end fund companies will disclose this as will other data resources to help provide insights.
Resources
Two great resources I use to get an intial look at closed end funds are CEFConnect.com and Morningstar. CEFConnect.com is a website dedicated to providing data on closed end fund. You can get funds’ asset allocation, performance, historical distributions, historical premiums/discounts, etc. Just a great resource to quickly find data. I also use Morningstar data through my Morningstar Direct system, which is more of an institutional version of their software. You can use Morningstar.com for free data if you are looking for information on closed end funds.