Open-end and closed-end funds are vehicles that enable investors to invest in professionally-managed portfolios of securities. Although they have some features in common, there are some major differences between open-end funds – which are better known as “mutual funds” – and closed-end funds (CEFs). While mutual funds are vastly more popular than CEFs, both face intense competition from the newest entrant in the fund space – exchange-traded funds or ETFs, which have grown by leaps and bounds in this millennium.
What are Closed-end and Open-end funds?
A closed-end fund is essentially an investment company that issues a fixed number of shares in an initial public offering, and invests the proceeds in securities such as common stocks, preferred shares, municipal bonds, and corporate bonds, depending on its mandate. After its IPO, the CEF’s shares trade on an exchange; just like a stock, the price of the fund’s shares is determined by supply and demand.
An open-end (mutual) fund also invests in stocks and/or bonds, depending on its investment objectives, but unlike a CEF, investors purchase shares directly from the fund itself. The price of the shares is determined by the fund’s net asset value (NAV) per share.
CEFs and mutual funds share the following similarities:
- Professional management – Both fund types are run by portfolio managers with the assistance of analysts.
- Diversification – CEFs and mutual funds mitigate security-specific risk by holding a diversified basket of securities.
- Economies of scale – A basic premise for fund investing is that pooling money from many investors enables investment and operating costs to be lowered through economies of scale.
Differences between CEFs and Open-end funds
Here are some of the fundamental differences between these two fund types:
- Number of shares – A CEF has a fixed number of shares,. In contrast, an open-end fund can issue any number of new shares or can redeem existing shares.
- Pricing – A CEF’s shares trade on an exchange, and as a result, they are priced throughout the trading day. Since their price is determined by supply and demand fundamentals, these shares often trade at a significant discount or premium to their net asset value. By contrast, shares or units of a mutual fund do not trade on an exchange, and are priced at per-share NAV (i.e. the fund’s total net asset value divided by the number of fund shares outstanding). The fund’s NAV per share is calculated at the end of each business day.
- Restrictions – CEFs have fewer restrictions than do mutual funds with regard to such factors as leverage and liquidity. Many CEFs use leverage as part of their investment strategy, although such leverage is subject to strict regulatory limits. As well, since CEFs do not have to maintain cash reserves or meet redemptions, they have greater leeway to invest in illiquid stocks, securities or markets.
Relative market size
Closed-end funds had a head start over their open-end peers, with the first CEFs being British investment trusts formed in the 1860s. Open-end or mutual funds in their present form came along much later, with the first ones in the United States launched in the 1920s.
The enormous disparity in assets between CEFs and mutual funds in the U.S. – which accounts for about 50% of global mutual fund assets – highlights the divergent fortunes of these fund types. According to the Investment Company Institute (ICI), total CEF assets in the U.S. at the end of the third quarter of 2013 stood at $277.08 billion. There were 604 CEFs in existence at end-Q3, which means that each CEF had an average of about $460 million in assets. Equity fund assets amounted to $110.40 billion (or about 40% of total CEF assets), while bond fund assets were $166.68 billion (60% of total CEF assets).
ICI statistics also showed that U.S. mutual funds had net assets of $14.3 trillion at the end of the third quarter of 2013, which means that the mutual fund industry was more than 50 times larger than the closed-end fund sector. As there were 7,605 mutual funds in existence at end-Q3 (almost 60% of which were equity funds), the average U.S. mutual fund had $1.88 billion in assets, making it four times as large as the average CEF. Equity fund assets were $7.1 trillion or about 50% of total mutual fund assets, while bond and money market funds accounted for $6.0 trillion or 42% of the total, and hybrid funds constituted the balance $1.2 trillion or 8% of total industry assets.
No discussion of the mutual funds and CEF market would be complete without looking at exchange-traded funds, so let’s look at the size of the ETF market. Total ETF assets in the U.S. stood at $1.54 trillion at the end of the third quarter of 2013, so despite their relatively recent entry into the marketplace, the ETF sector already surpasses the CEF sector by more than fivefold. There were 1,264 ETFs in existence as of end-Q3, which means that the average ETF had assets of $1.2 billion, almost three times the size of the average CEF.
Points to consider
- Past performance is no guarantee of future results – This is boilerplate disclosure in most fund prospectuses, but how many investors really pay attention to it? There is sufficient evidence to show that the best-performing funds have a hard time replicating their success over the long term, something that should be borne in mind the next time you are tempted to get into a hot fund.
- Fees can really eat into returns – Inordinately high management fees can erode investment returns significantly over time. So can other fees such as a sales charge (also called a “load”, perhaps because it is a heavy burden for the buyer to bear?) and switching fees. Don’t forget to check out the fee schedule before buying a fund.
- CEFs may have other trading costs – Closed-end funds may impose other costs through wide bid-ask spreads for illiquid funds, as well as volatile premium/discount to NAV. For example, you may buy a CEF share for $9, which represents a 10% discount to its NAV of $10. If the NAV goes up to $11 but the discount widens to 20%, your share would be priced at $8.80. Check the bid-ask spread, and more importantly, the long-term trend for the fund’s premium or discount to NAV.
- A couple of CEF pointers – Most experts advise against buying a CEF at its IPO, since it is likely to be trading close to NAV when it first trades, but at a significant discount to NAV later on. Also, is it really advisable to pay such hefty premiums for some CEFs? For instance, PIMCO’s Global StockPlus Fund (NYSE:PGP) and High Income Fund (NYSE:PHK) were trading at premiums to NAV of 58% and 46% respectively in the first week of December 2013, according to Morningstar. This means that an investor is paying $1.58 and $1.46 per dollar of assets in these funds.
- Is there an ETF for that? – The combined pitfalls of mutual funds and CEFs can be sidestepped by checking to see if there is an ETF for the same sector or market (chances are there is one). ETF assets had grown to $1.5 trillion by end-Q3 of 2013, thanks to their many advantages such as instant liquidity, lower fees, plethora of choices, and narrow trading spreads.
The Bottom Line
Closed-end funds initially made their mark by investing in investment niches such as preferred shares, emerging markets, high-yield bonds and small-cap stocks. But the rapid emergence of ETFs in these niches and other broad areas of the market threatens not just the long-term viability of CEFs, but poses a formidable challenge to the dominance of mutual funds as the investment of choice for retail investors.
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