Most investors understand the basics of ordinary mutual funds, but I’m confident few understand closed-end funds that also hold a portfolio of stocks and bonds, how they differ and their risks. They are in some ways like mutual funds and exchange-traded funds but also have significant differences.
Mutual funds continuously sell and redeem shares at the net asset value of the underlying portfolio. CEFs don’t do that; they sell common stock only once and don’t redeem shares. Shares are traded on a stock exchange at whatever price supply and demand set. This price may have little to do with the net asset value of the underlying portfolio. Thus, CEFs are like ETFs that also don’t continuously buy and sell shares directly to investors. Unlike CEFs, however, ETFs have a complex share redemption/creation feature, which generally ensures that the share price stays close to the net asset value.
Another key difference: Mutual funds are only priced once a day, at 4 p.m., while close-end funds and ETFs are priced continuously. ETFs and CEFs both release their net asset value daily.
While CEFs only sell common stock shares once, they can also sell preferred stock and issue long-term debt. Those that do use these funds to buy more of the underlying assets and thus leverage their portfolio, increasing risk and, possibly, return. Mutual funds and ETFs can’t issue preferred stock. While some ETFs use debt to leverage their portfolios, mutual funds are more constrained. Leverage enters in another way; mutual funds can’t be bought on margin while both CEFs and ETFs can. Additionally, mutual funds can’t be sold short while ETFs and CEFs can. The latter two are also allowed to have listed options while mutual funds can’t.
CEFs have more flexibility than mutual funds and ETFs in holding unlisted or illiquid securities — those that can’t be sold quickly at a price close to their net asset value. This flexibility can be a mixed blessing for an investor because the illiquid security’s actual value could differ significantly from the CEF’s estimate.
CEFs management fees are generally higher than ETFs and often are higher than actively managed mutual funds.
Why might an investor consider a CEF?
Since CEFs’ prices vary from their net asset value, it’s relatively easy to find a CEF investing in the securities an investor is interested in that is selling at a discount to net asset value. Recently, the median discount of all CEFs was about 5.3 percent but some were in the high teens. But some CEFs sell at significant premiums.
Additionally, sometimes an investment firm has a mutual fund and a CEF with essentially the same portfolios. The mutual fund might be selling with a 4.25 percent front-end load while the CEF could be selling at a discount of 5.3 percent. Both funds’ expense ratios would also need to be considered before a decision.
Note to Readers: I will give a complimentary seminar on “Generating income from your investments” from 1:30 to 3 p.m. Dec. 6 at the Sarasota Yacht Club. Call 800-734-7171 for reservations.
Send comments and questions to Robert Stepleman, Dow Wealth Management, 8205 Nature’s Way, Lakewood Ranch, FL 34202, or firstname.lastname@example.org. Follow him on Twitter @logicalinvestor. Stepleman is associated with Dow Wealth Management LLC as a lecturer and chief portfolio strategist. He offers advisory services through Bolton Global Asset Management, an SEC-registered investment adviser. Past performance is not indicative of future results. The data and performance information is for informational purposes only and is not intended as a solicitation.
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