Frequently Asked Questions - Closed-end funds

Closed-end funds

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What is a closed-end fund?

A closed-end fund (CEF) is a mutual fund with a fixed number of shares. In other words, new shares are not created to meet investor demand.

Capital is raised through an initial public offering (IPO) after which CEFs are listed on a national exchange such as the New York or London Stock Exchange. Here, investors are able to buy and sell the CEF's shares in transactions with other investors. The share price is therefore determined by market demand and not the fund’s net asset value (NAV).

Additional CEF shares can only be created through secondary offerings, rights offerings or the issuance of shares for dividend reinvestment.

What is the difference between a closed-end and open-end fund?

Whereas with open-end funds (OEFs) new shares are created to meet investor demand, closed-end funds (CEFs) have a fixed number of shares and additional shares can only be created through secondary offerings, rights offerings or the issuance of shares for dividend reinvestment.

Furthermore, OEF unit prices are determined by the fund’s net asset value (NAV), defined as the current value of its assets, less liabilities, divided by the total shares outstanding, which is calculated at the end of each business day. In the case of CEFs, which are listed on a recognised exchange and are bought and sold by investors, the share price is determined by market demand, not the fund’s NAV, and therefore fluctuates throughout the day.

It is worth noting that an OEF can for various reasons be ‘closed’ to new investments. This is not to be confused with a CEF.

How does the nature of closed-end funds affect portfolio management?

Given the nature of closed-end funds (CEFs) i.e. they are not subject to the constant in and outflow of cash, they have a relatively stable asset base. This removes the constant pressure of having to react to investor demands, with the result that CEF managers are able to use their own judgement to make investment decisions.

How is the value of closed-end funds determined?

Closed-end fund (CEF) shares are not traded at net asset value (NAV), but rather at a price determined by the market. In other words, the market price of a CEF is either more or less than the NAV. Historically, most CEFs trade at a discount to their underlying NAV – sometimes as high as 25%. While the reason for this has yet to be understood, it is an anomaly that should be exploited by investors.

What are the leverage benefits of the net asset value discount?

The net asset value (NAV) discount creates interest-free leverage as well as the potential for magnified capital growth and magnified yield. However, it is important to note that the benefits of leverage are nullified by negative fundamentals and fund managers and investors have to contend with the prospect of magnifying losses.