Saturday, September 19, 2009

Closed end mutual funds

There currently are three different types of mutual funds one can invest in--open end mutual funds, exchange traded index funds, and closed end funds. This is a discussion of closed end funds.

Closed end funds are bought and sold on stock exchanges very much like exchange traded index funds. As of this posting there are about 630 different closed end funds available. Very similarly to open end mutual funds they come in a wide variety of different types. Some are municipal bond funds, some taxable bond funds, and others covering a wide variety of equity investment categories.

There are several specific differences between closed end funds and open end funds however.

First they are traded on the stock exchanges. As a result they do not necessarily trade at net asset value. In fact sometimes the price at which they do trade varies greatly from the value of the net assets. At the time of this posting, one astonishingly sells at a premium of 73% to net assets. Back in March 2009 it sold at a slight discount. It is not all that uncommon for a closed end fund to sell at a premium to net assets but the vast majority do not. Currently about 160 do and 470 do not. Occasionally, some closed end funds will trade at a substantial discount to net assets especially during market panics. During the March 2009 market panic there were many closed end funds selling at 20+% discounts to net assets. There are currently about 15 or so trading at such a discount perhaps for some good reason. However, if one can purchase a mutual fund at a substantial discount to net assets, one might give such a fund careful consideration.

A second difference is that most closed end funds are considerably smaller than most open end funds. the largest has $3.3 billion in assets. The median about $200 million in assets. The number of shares outstanding is generally a fixed number of shares. Unlike an open end fund, they do not issue new shares at public demand and they do not redeem shares at public demand. They do occasionally issue new shares to cover dividend reinvestment. And they do occasionally liquidate. There is one ramification of this aspect. That is that in general it is a great deal easier to manage a small mutual fund than it is to manage a larger mutual fund. Fidelity Contrafund has $51 billion in assets. American Funds Capital Income Builder has $75 billion in assets. With such a large asset base it is also more difficult to diverge from the market average. They are the market average. The two specifically mentioned have managed to diverge positively from the market average, but most have not.

A third difference is that many closed end funds employ leverage, which can work for them in a rising market but against them in a falling market. Not all do but many do. The leverage is in the form of preferred stock and usually represents 30-40% of capital. Many of these closed end funds had issued auction rate preferred stock. A result of the banking crisis was that virtually all of this type of preferred stock became untradable. This led to some difficulties for several closed end funds. Another difficulty many closed end funds encountered was that as the value of their assets decreased during the market collapse of 2008-9, their leverage ratios increased beyond the regulatory limits for their particular funds--33% for debt leverage and 50% for equity leverage. The drop in asset values ment that they had to reduce their leverage, which ment selling assets at distressed prices. Not a particularly good position to be in.

During more normal market conditions there is about $20-30 billion in new closed end funds issued on an annual basis. Recently there have been virtually none issued. Buying a closed end fund IPO is a loosing proposition in general. The IPO is generally issued at a premium of about 5% to net assets. Once the fund begins trading there is about a 80% probability that the market price will fall to about a 6-10% discount to net assets. There are certain exceptions to this generality. In 2006 Morgan Stanley China A Share Fund came to market. This particular fund invested in a market that virtually no other mutual fund invested in and a market closed to individual foreign investors--China A shares. The fund immediatedly soared to a premium and during 2007 returned 100%. It now sells at a very small premium of 3% but as resently as April 2009 sold at a premium of 30%.

There are two web sites that give a good statistical analysis of closed end funds.


  1. A smart option on investing you funds @ Muncie great job!

  2. Great article. Too few investors use closed end funds. I have never lost a dime in one.
    PS. I saw a pileated woodpecker up close today. It was down by the river. I was maybe 10 foot from it. Wish I had my camera.