Closed-end Fund - Distinguishing Features

Distinguishing Features

Some characteristics that distinguish a closed-end fund from an ordinary open-end mutual fund are that:

1. it is closed to new capital after it begins operating, and
2. its shares (typically) trade on stock exchanges rather than being redeemed directly by the fund.
3. its shares can therefore be traded at any time during market opening hours. An open-end fund can usually be traded only at a time of day specified by the managers, and the dealing price will usually not be known in advance.
4. a CEF usually trades at a premium or discount to its Net Asset Value. An open-end fund trades at its Net Asset Value (to which sales charges may be added; and adjustments may be made for e.g. the frictional costs of purchasing or selling the underlying investments).
5. in the United States, a closed-end company can own unlisted securities.

Another distinguishing feature of a closed-end fund is the common use of leverage or gearing to enhance returns. CEFs can raise additional investment capital by issuing auction rate securities, preferred stock, long-term debt, and/or reverse-repurchase agreements. In doing so, the fund manager hopes to earn a higher return with this excess invested capital.

When a fund leverages through the issuance of preferred stock, two types of shareholders are created: preferred stock shareholders and common stock shareholders.

Preferred stock shareholders benefit from expenses based on the total managed assets of the fund. Total managed assets include both the assets attributable to the purchase of stock by common shareholders and those attributable to the purchase of stock by preferred shareholders.

The expenses charged to the common shareholders are based on the common assets of the fund, rather than the total managed assets of the fund. The common shareholders' returns are reduced more significantly than those of the preferred shareholders because the expenses are spread among a smaller asset base.

For the most part, closed-end fund companies report expense ratios based on the fund's common assets only. However, the contractual management fees charged to the closed-end funds may be based on the common asset base or the total managed asset base.

Long-term debt arrangements and reverse repurchase agreements are two additional ways to raise additional capital for the fund. Funds may use a combination of leveraging tactics or each individually. However, it is more common for the fund to use only one leveraging technique.

Since stock in closed-end funds is traded like other stock, an investor trading them will pay a brokerage commission similar to that paid when trading other stocks (as opposed to commissions on open-ended mutual funds, where the commission will vary based on the share class chosen and the method of purchasing the fund). In other words, closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. The main exception is loan-participation funds.