How Does a Closed-end Fund Differ from a Mutual Fund?
A) No Constant Inflow and Outflow of Money
A significant difference is that a CEF does not have a constant inflow or outflow of cash. Mutual funds take in new money from, and issue new shares to, each new investor. In most instances, when a mutual fund investor decides to sell his or her shares, they are redeemed by the mutual fund at the fund’s NAV. Accordingly, the mutual fund typically must either keep enough money on hand (and therefore not invest it in securities) to meet redemptions or sell existing positions to raise the money to pay redemptions. This can force the mutual fund manager to sell off portfolio holdings based on demand from shareholders who want to get out of the fund, which can often happen at the absolute worst time, such as a sharp market downturn. The constant inflows of money can also make mutual funds victims of their own success. The inflows must be invested by the portfolio manager at times when good investment opportunities may not exist, which can create a drag on the fund’s performance.
As discussed in D below, the shares of a CEF, on the other hand, are traded in the public market and the buying and selling of the CEF’s shares does not result in any inflow or outflow of money in the CEF. A CEF does not have to make redemptions (and it can remain fully invested) or figure out how to put inflows of money to work. The portfolio manager is thus able to better control the timing of when portfolio securities are bought or sold and can choose the time horizon for his or her investments that best fits the fund’s philosophy. This can be especially important in market downturns. This stable environment permits the CEF portfolio manager to concentrate on achieving long-term goals rather than reacting on short-term market considerations.
B) The Closed-end Fund’s Focus is on Current Shareholders
With a fixed amount of capital, a CEF is not generally involved in attracting additional funds and the CEF shareholder is not required to pay for the costs of attracting new investors. The mutual fund portfolio manager, however, has an incentive to attract new shareholders to maximize fees. In order to market the mutual fund to new shareholders, current mutual fund shareholders are often charged a front-end or back-end load and marketing fees, commonly known as 12b-1 fees, which reduce the current shareholders’ returns. In contrast, CEF investors are not burdened with these fees. Thus, the CEF portfolio manager is able to focus on returns for current shareholders, not on attracting new ones.
The drive for more and more new shareholders may also cause the mutual fund portfolio manager to fall into the “quarterly performance derby” trap in which he or she is forced to be on the lookout for the latest, hottest security to keep his or her performance up. This may lead to increased turnover in the stocks held in the portfolio and may result in substantial tax consequences and expenses incurred by the fund for the mutual fund investor.
C) The Opportunity to Buy at a Discount
The market sets the price of a share of a CEF, and the shares can trade at a discount or premium to the fund’s NAV. By buying shares at a discount, an investor can earn added returns. One way this happens is because income is earned and gains are realized on the CEF’s total assets. So an investor receives the return on a dollar of assets even though he or she paid less than a dollar for those assets, due to the discount. In addition, the discount may narrow over time (of course, it also could expand, depending on the market), which can also result in a higher yield on the initial investment. The discount also provides a shock absorber when the broader markets drop. Because an investor was able to pay less than NAV for the shares, the investor who has bought the stock at a discount has a cushion against a drop in the value of the portfolio resulting from a market downturn. Thus, a number of advisers have observed that one way of looking at the discount is as a bonus that may produce added returns over time.
D) The Benefits of Trading on an Exchange
Finally, because a CEF trades on an exchange, an investor who sells gets the current price for the shares, knows immediately what that price is and the amount that was realized on the sale, and does not have to wait until the end of the day to find out what the selling price was*. A CEF must also abide by the rules and regulations of the exchange on which its shares trade, thus adding another layer of protection for shareholders. ]
*Note that these considerations may not apply to CEF investors who sell their shares through a fund’s dividend reinvestment plan. Such plans frequently provide that sales will only be made on a weekly or monthly basis, as demand and market conditions justify. Thus, an investor in a dividend reinvestment plan may not be able to set the exact date for when the shares are sold. In addition, the sales price received will most often be an average price that is not determined until after the sales are completed. You should consult the terms of your dividend reinvestment plan to see how they apply to your investment.