By Lucas Hsu
Most investors are familiar with mutual funds, a form of investment company regulated by the Securities and Exchange Commission under the Investment Company Act of 1940. In fact, a majority of investors’ retirement and taxable investment accounts are comprised of mutual funds. However, investors are often unaware of another type of investment company, called a closed-end fund (CEF). Unlike mutual funds, which represent $18.7 trillion in assets, CEFs hold over $300-billion in assets.
Unlike mutual funds, which offer an unlimited number of shares to investors, CEFs only offer a fixed number of shares during the fund’s IPO. Following this initial sale, investors have an opportunity to buy these shares on a secondary market, such as the NYSE or the Nasdaq Stock Market. In a secondary market, investors can often buy CEF shares at a discount, which means the price of a share is less than the value of the assets held in the fund. The benefit of the discount is realized when a CEF becomes popular. As the market demand goes up, share prices also go up, which in turn increases the return on investment. Also, the use of an IPO creates “a solid base of capital” that allows a fund manager to buy riskier, but potentially more profitable assets, such as those in emerging markets or real estate deals.
Additionally, CEF managers have the ability to use leverage to “double down” on winning positions. This makes a closed-end fund attractive to the income focused investor because the CEF’s gains will be amplified in a rising market, leading to higher yields. However, the use of leverage is a double-edged sword. Rising interest rates can lead to a reduced payout and a decrease in the value of the individual securities held by the fund. Furthermore, investors cannot assume that the distribution they are receiving comes from the income generated from the securities in which the fund is invested. These distributions may be a return of capital, which is simply the fund returning shareholders’ money.
Before diving head first into a CEF, it is a good idea to do more research by carefully reading the CEF’s prospectus in order to understand its investment objectives and the risks involved. Additionally, investors may also refer to the SEC’s information page regarding CEFs, as well as, FINRA’s Investor Alerts page in order to properly determine whether a CEF is the right investment for their portfolio.