Closed-end funds grow popular

Funds allow investors the ability to obtain diversification by pooling their dollars together.  Investors must be careful to pick the fund managers they feel will do the best job.  With the number of funds steadily increasing this is not an easy task.  In addition, there are a variety of different funds available with different investment objectives, strategies, and portfolios.

The purpose of this column is to discuss investment strategies with respect to “closed-end” funds.  It is important for investors interested in funds to obtain an understanding of the difference between “closed-end” and “open-end” funds.

Open-End Funds

Most of the funds on the market place are open-end funds (OEF), which generally have no restrictions on the amount of shares the fund will issue (unless a fund manager closes the fund to new purchases). The fund will continuously issue shares and also buy back shares when investors wish to sell.  OEFs are issued by an investment company, and are subject to certain disclosure rules.  After purchasing an OEF you will generally receive a full prospectus in the mail outlining the funds investment objectives, strategies and fees.

Closed-End Funds

Growing rapidly in the market place are closed-end funds (CEF).  The initial public offering is generally done through a prospectus, similar to OEF.  This document is intended to provide investors complete information on the structure as well as all applicable fees.  We encourage investors to read this document.  As an example, the prospectus may specifically state whether the CEF may use leverage within the structure.

Important Difference

CEFs do not continuously offer their units for sale as an OEF would.  CEFs sell a fixed number of units at one time, through the initial offering.  After the initial offering the shares typically trade on a secondary market, such as the Toronto Stock Exchange (TSX).  CEFs trade on an exchange much the same way as individual equities.

Net Asset Value

OEFs are bought and sold at net asset value (NAV) directly from the fund company.  NAV is the total value of the fund’s portfolio less liabilities generally calculated on a daily basis.  As noted above CEFs trade on an exchange after the initial public offering.  As a result, they are generally bought or sold at a discount or premium to its NAV.  Although a fund company does not redeem CEF units, most disclose their NAV daily.

Discount

When CEFs disclose their NAV, these may be compared to the most recent trades in the secondary market.  Investors who look at the various CEFs offered in the secondary market may find that most trade at a discount to their NAV.  It is not uncommon to see some CEFs trading at a discount of 5 to 10 per cent or more during market volatility.  This may be a little frustrating for investors who purchased a CEF at the initial issue and are now looking at selling their units.  On the flip side, opportunities may become available for investors looking on the exchange for deep discounts (large differences between NAV and market value).

Liquidity

Some CEF investments are not redeemable for a period of time.  CEFs are generally structured so they are not required to buy units back from investors until maturity of the structure.  CEFs therefore may not be suitable for individuals who desire liquid investments.  CEFs are generally not redeemable by the company (see redemption privileges below).   Investors should use caution prior to selling CEFs on the secondary market.  Many CEFs have very little trading volume and care should be taken before entering “market” orders.  Prior to making a CEF purchase on the secondary market, investors may be able to look at the historical volumes and total issue size of the CEF.  This may provide some indication as to the future liquidity.

Volatility

As noted above, the trading volumes on CEFs may be very low.  In some cases the spread between the bid and the ask may be significant.   Once a secondary market exists for a CEF, investors are able to sell their units if there are buyers.  It is not uncommon to see a significant change in the market price of a CEF when an investor sells a large position.

Redemption Privilege

One feature that investors should consider prior to purchasing a CEF is if the offering document provides for a redemption privilege.  Some of the original CEFs do not have a redemption privilege.  We would expect some of these CEFs to possibly trade at a greater discount than those that have redemption privileges.  Most of the newer CEFs provide some form of redemption privilege.  The more frequent the redemption privilege the more flexible for the investors.  Some offering documents provide redemption privileges equal to 100 per cent of NAV.  Other less attractive CEFs may have redemption privileges equal to 90 or 95 per cent of NAV.  Individuals who have closed end funds should be aware of these redemption dates, if applicable.  The offering document generally provides full details with respect to redemption privileges.

Ongoing Management

Companies may establish a CEF (rather than an OEF) for the ease of administration.  After the initial offering, management knows the amount of funds available for investment purposes.  Administratively they do not have to be concerned about additional purchases or early redemptions.  Redemption rights by investors generally must be provided to the issuer well in advance and settlement may be longer than the normal three days.

Income Payments

CEFs may be structured in a manner that provides a regular stream of income to investors.  Some structures are more beneficial in a non-registered account if the income payments are tax efficient.

Typical CEFs

The following are the main categories of CEFs:  global equity, income and growth funds, fixed income funds, preferred share funds, income trust funds, commodity funds, infrastructure funds, and alternative asset management funds.

We encourage all investors considering a closed end fund to understand the limitations and risks.