Zaks Investment Advisory Service

Closed-End Funds: How They Work and Differ from Mutual Funds

Last time we talked about Index Funds, mentioning how there is now a certain new asset class called Exchange Traded Funds (ETFs), which in many ways resemble Index Funds. But before discussing Exchange Traded Funds, let us talk about Closed-End Funds: to a certain extent, Exchange Traded Funds resemble them, too. Closed-End Funds, just like regular Mutual Funds, issue shares. As we know, Mutual Funds use the money from these share sales to purchase various securities: stocks (of both American and foreign companies), and various bonds, bills and notes. When we discussed Mutual Funds, we mentioned how they issue and sell their own shares. In other words, if you wish to purchase shares of, say, Fidelity Magellan, then you hand your money to the Fidelity company, which in turn hands you documents confirming that you are a partial owner of the Magellan fund. If you decide to sell your part in Magellan, then you also do this directly to the company: requesting the return of your investment, you receive cash corresponding to the value of your share in Magellan. In this manner, if numerous investors decide to purchase the very same Mutual Fund, its share price could rise dramatically – which is what happened to Magellan in its time. Theoretically, the amount of money that may be invested in a Mutual Fund is limitless. The fund’s managers use all the additional investments to purchase securities. But should investors suddenly decide they no longer liked the fund (which also happened to Magellan at a certain point), they would redeem their Mutual Fund shares and force the managers to sell securities in order to raise the corresponding cash – regardless of whether they wanted to sells their securities or not.

Closed-End Funds are organized differently and have no such problems. Just like Mutual Funds, Closed-End Funds initially issue shares and buy securities on the raised cash. But in contrast to Mutual Funds, Closed-End Funds issue a limited number of shares. Suppose that a Closed-End Fund issues shares worth $100 million. The money raised from its own share issue will go toward the purchase of various securities. And the shares of the Closed-End Fund itself will start getting traded on the open market. In other words, if you wish to buy shares of a certain Closed-End Fund, you will have to do so on the open market, just like the shares of any other “regular” company. As a result, the number of shares of a Closed-End Fund remains constant: if you are buying shares of a Closed-End Fund, it means that another investor is selling them.

There are about 700 Closed-End Funds. There are, of course, far fewer of them than regular Mutual Funds (which number more than 8,000), but that figure is still quite substantial. Their assets value is around $300 billion – another impressive sum.

Why do investors buy Closed-End Fund shares? For the same reason they invest in Mutual Funds: both types of funds allow investors to diversify their portfolios. And just like with Mutual Funds, Closed-End Funds are run by professional managers. Imagine that some American decides to invest in Russian company shares. Until recently, the opportunities for doing so were limited. Perhaps one of the best options was through the Templeton Russia Fund (TRF). It is an American Closed-End Fund that invests in shares of Eastern European (predominantly Russian) companies. The fund’s assets are composed of shares of various companies. If the share prices of Russian companies grow, then TRF assets grow along with them, or to be more precise, its Net Asset Value grows (i.e. the difference between the fund’s assets and liabilities). Since its Net Asset Value (NAV) is growing, then most likely the shares of the fund itself are growing, too. And the opposite, if the shares of Russian companies drop, then, as a result, the shares of TRF fall too. In this manner, an American investor can participate in the Russian market.

You may have noticed I said that if the fund’s Net Asset Value grows, then most likely the fund’s shares would rise, too. The fact is that Closed-End Fund shares trade on the open market at prices determined by the market itself, and like all other shares, they constantly change in price. Closed-End Funds thus differ from regular Mutual Funds. As you probably recall, Mutual Funds sell their shares at the NAV price (to which commission fees are sometimes added). They buy them back at that same price when investors decide to sell their shares. But Closed-End Fund shares are sold on the open market and there is no law that says shares must be traded at their Net Asset Value price. In other words, you are buying shares at market, and not NAV, prices. The market price may diverge from the NAV by quite a lot. It may be both higher and lower than the NAV. For example, shares of the above-mentioned TRF fund at one stage traded 20 percent lower than their NAV (i.e. they “traded at a discount”), and at another – were 40 percent more expensive than their NAV at the time (i.e. they “traded at a premium”). Thus, one has to be careful buying Closed-End Fund shares: their share prices just might go down while the NAV goes up, all of it because of a drop in premium.

The second difference between Closed-End Funds and Mutual Funds is linked to how these companies’ shares are bought and sold. We just mentioned that Mutual Funds buy and sell their own shares. If, for some reason, investors start taking money out of a fund, then its managers may be forced to sell some of their assets in order to settle with the investors. Sometimes this happens at a point when the last thing a manager wants to do is sell assets. These situations may lead to additional expenses that, of course, are paid for by the remaining investors.

Today we had a brief discussion about Closed-End Funds. Next time we will focus on Exchange-Traded Funds. This was Sergey Zaks. Thank you for your attention and until next time.