Another exchange traded option is investments in closed-end mutual funds. While often run by well-known operators of traditional, open-end mutual funds, closed-end funds are very different from their open-end counterparts. A closed-end fund is an investment company which generates all of its initial capital from the sale of shares. Officially, these “funds” are actually classified as closed-end companies by the SEC (click for a detailed description from the SEC). The company then invests this capital under the strategy and guidance of a portfolio manger similar to how an open-end fund would though since the fund’s shares represent an investment company as opposed to actual assets, closed-end funds typically have to focus on capital appreciation and revenue from its investments as opposed to simply capital preservation. As a result, most closed-end funds typically have more aggressive strategies than their open-end counterparts. The companies may even use leveraging or raise funds through preferred stock or long-term debt in order to enhance return for its shareholders.
The shares issued by the closed-end fund do not have redemption value and instead just represent part ownership of the fund. Shareholders are essentially part owners and, while they don’t have direct control over the fund’s investment decisions, they can do things like participate in shareholder activism if they believe the fund is being mismanaged. The only difference from being shareholders of more traditional stock versus shareholders of a closed-end fund lies in the fact that the funds initial capital comes entirely from the share offering. Further, closed-end funds will rarely redeem their shares or issue new shares. As a result, it is rather easy to calculate what should be the initial value for the company/fund.
There are both advantages and disadvantages to investing in a closed-end fund versus an open-end fund. A closed-end fund offers security in knowing that the funds capital is fixed. Since owners of the fund simply trade the shares rather than redeem them from the mutual fund, the manager does not need to worry about keeping cash or having to sell positions in order to repay investors who want to leave the fund. As a result, closed-end funds typically remain more fully invested than open-end funds. Without fear of losing capital from poor near-term performance, theoretically, a closed-end fund can also make more long-sighted picks. Furthermore, since closed-end funds don’t need to worry about creation and redemption of shares, management fees tend to be much lower than open-end funds.
Simply put, one can view closed-end funds as a sort of mix between open-end mutual funds and index linked exchange traded funds. They offer professional management and a broad mix of strategies including strategies that give you access to a similarly broad range of asset classes, industries, and countries as ETFs. For example, one could invest in a Taiwan ETF like the iShares MSCI Taiwan (EWT) and bet on the Taiwanese market in general or use a closed-end fund like the Taiwan Greater China Fund (TFC) and gain access to Taiwan with a more targeted investment strategy. That being said, your money is not being directly managed by the manager and there are few more inherent risks in owning shares in a closed-end fund.
First and foremost, since the shares do not represent underlying assets as in an ETF and only represent ownership in the fund, their pricing is determined almost entirely by the market. This means that they can trade for large (sometimes greater than 10%) premiums and discounts from Net Asset Value (the total value of the assets that the fund has invested in). This is both an advantage and disadvantage. Buying funds priced at a discount offers the potential to not only gain from appreciation in the fund’s investments but shrinking of the fund’s discount thus magnifying returns for an investor. Should a fund be trading at a premium and find its performance decline, then the share’s performance may also be affected by shrinking of the premium thus magnifying loss. This characteristic is the basis for a quick strategy on playing closed-end funds. Since Net Asset Value is very easily calculated for closed-end funds (all the assets are in their holdings and very well reported), finding funds trading at significant discounts to net asset value offers a high likelyhood of return provided that you can ascertain that the fund managers will at least maintain a modicum of performance (i.e. not loose money). The danger here is there’s no telling how long the discount will last so you may not be able to get the return you envisioned in the time frame you want. But, you can sleep easy knowing that in the very unlikely case that the fund is liquidated, you’ll be looking at guaranteed profits .
Second, as with all stocks traded in secondary markets, closed-end funds can suffer liquidity risk which can make it difficult to buy or sell the stock at the exact price you may want to. Closed-end funds can suffer from this significantly as they are often not as popular as other exchange traded instruments. While closed-end funds do typically perform about as well as the performance of their net assets, they can also be analyzed as companies as far as assessing the performance of management, management of leverage, and consistent earnings and paying some attention to this can really help with regards to picking the right funds for your portfolio.
For more information on closed-end funds, check out this article on Top Performing Closed-End Funds. As you might be able to tell from the list, many popular closed-end funds are those that target international investments and are usually run by big name asset management firms like Morgan Stanley and BlackRock. As new, high-profile ETFs launch, these funds are getting increasingly unpopular despite the fact that many of them have been performing extraordinarily well. As a result, closed-end funds are fast becoming a very good way to play emerging markets on the cheap as it is possible to find many of them trading at a discount. Check out this article listing closed-end funds trading at a significant discount to NAV.
For a look at two well-known operators of closed-end funds, check out Gabelli Investor’s Inc. which has operated the Gabelli Equity Trust (GAB) since 1986 and is headed up by famous value investor, Mario Gabelli and Adams Express Company (ADX)which has been managing itself as a closed-end fund for over 77 years.
On the Other Hand
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