What is a closed-end fund (CEF)?
– A closed-end fund is an investment company that raises a fixed amount of capital by selling a set number of shares in an initial public offering (IPO). After the IPO the fund’s shares trade on an exchange like a stock; the fund generally does not issue new shares or redeem existing ones. A professional manager runs the portfolio, buying and selling securities on behalf of shareholders.
How CEFs differ from open-end funds (mutual funds, most ETFs)
– Share issuance: Open-end funds create and redeem shares continuously to accommodate investor flows. CEFs issue shares only once (except some special “interval” funds that periodically repurchase).
– Trading and pricing: CEF shares trade intraday on an exchange at market prices determined by supply and demand. Open-end funds price once per day at net asset value (NAV).
– Liquidity source: CEF liquidity comes from the secondary market (a broker and another investor). Open-end funds buy or sell directly with the fund company.
– Use of leverage: CEFs more commonly borrow (use leverage) to amplify returns, which raises both potential gains and potential losses.
Key terms (short definitions)
– Net Asset Value (NAV): (Total assets − Liabilities) ÷ Shares outstanding. NAV is the per-share value of the fund’s underlying portfolio.
– Premium/discount: The percentage difference between the market price and NAV. Price > NAV = premium. Price < NAV = discount.
– Leverage: Borrowed money used by the fund to increase its investment exposure.
How NAV and market price interact (formula)
– NAV per share = (Total assets − Total liabilities) ÷ Shares outstanding
– Premium or discount (%) = (Market price − NAV) ÷ NAV × 100%
Why CEFs can trade at a premium or discount
– Investor sentiment: Popular managers or hot sectors can push market price above NAV; underperformance or illiquidity can push price below NAV.
– No continuous share creation: Because shares aren’t created or destroyed to meet demand, market prices can deviate from NAV for extended periods.
– Distribution expectations and leverage: High distribution yields can attract buyers, but if distributions are unsustainable, prices can fall.
Common advantages
– Potentially higher yields: Because many CEFs use leverage and don’t keep large cash reserves, they can offer higher distribution yields than comparable open-end funds.