Chances and Risks of Closed-End Funds - Term Paper Example

 Chances and Risks of Closed-End Funds 2.0 What Is a Closed-End Fund? A closed-end fund collects a predetermined amount of fund through an Initial Public Offering from the capital market by issuing a fixed number of shares. Thus, outstanding shares of the closed-end fund remain fixed once initial offering is over. Unlike open-end mutual funds they are listed in the stock market to provide the liquidity to the investors. (Closed-End Fund 2010) 2.1 Statutory Standings of Closed-End Funds These funds are regulated as per the Securities Act of 1933, the Securities Exchange Act of 1934 and Investment Company Act of 1940. A closed-end fund needs to register with the Securities and Exchange Commission (SEC). They are managed by either as board of trustees (if formed as trust) or board of directors (if formed as a corporation). The board hires a fund manager to work as per the objective of the fund and in the best interest of the investors. (Closed-End Funds 2007) 2.2 Differentiation between Closed-End Funds and Common Funds Closed-End Fund differentiates from the conventional mutual fund or open-end fund in many respects. They can be described as per the following. 1. An open-end mutual fund approaches the market without any restrictions to issue the shares in terms of amounts. It continues to collect the fund as far as investors are ready to subscribe while for closed-end funds, it is simply a one-time affair to collect the funds through IPO that is kept open for a fixed duration of time. (Closed-End Fund 2010) 2. The typical characteristic of the open-end fund is to quote rates both way for buying and selling of the share. 3. After an initial issue of shares in the close-ended fund, they are listed in the stock market for trading just like other shares of the companies. Open-ended funds are not listed in the stock market because they themselves provide the liquidity by offering buying and selling prices. 4. The close-ended funds are sometimes meant for fixed duration of time. They are also known as interval funds. On the expiry date, the shares are redeemed at the available net asset value (NAV). Open-end fund does not have any fixed duration and they are always open for buy and sell of their shares. Any investor can enter or exit the fund at the offered price of buy and sell. (Closed-End Fund 2010) 2.2.1 Difference between Closed-end fund (CEF) and Exchange-traded Fund (ETF) The closed-end funds and ETFs both may appear quite similar; nevertheless, some characteristics differentiate them. Both are traded on a stock exchange. The primary difference between them is that closed-end funds are actively managed compared to ETFs that are passively managed. The portfolio that ETF manages is in public knowledge but in case of CEF it is not publicly known at all times. ETFs closely follow the NAV of the underlying portfolio, this is in stark contrast to the CEFs who do not trade near to their NAV. Moreover, tax treatment for both kinds of funds is also different. (Goodboy 2010) 2.3 Examples of Closed-Ended Funds (CEF) The close-end funds can be classified as per their investment types. Some of the major categories are money market funds, equity funds, fixed income funds, real estate funds, emerging market funds and many more. These funds are managed by the experts called fund managers who know the vagaries of these markets much better than any ordinary investor. Below mentioned graph shows year-wise investment of closed-ended funds in billions of dollars. The example shows two broader classifications of investment, equity and bond. Source: http://www.icifactbook.org/fb_ch4.html Some of the closed-ended funds can be classified as per the following. 2.3.1 Equity Funds Equity is the second largest investment area for the closed-ended funds. Domestic equity funds mostly go for investment in the US listed common stocks. There are also specific international equity funds who invest in foreign equities besides investing in U.S. securities. Many of them are heavily diversified across many countries. (Mazzilli, 2011) 2.3.2 Municipal Bond Funds Almost 50 percent of the assets of the CEFs are invested in Municipal bonds, state or local government bonds. The advantage is that they get exemption from paying federal income tax in their current income earnings. Single-state municipal funds are exempt from paying any state taxes. (Mazzilli, 2011) 2.3.3 Taxable Bond Funds These funds invest in taxable fixed income bonds or other debt instruments. Many of them are well diversified across multi sector bonds. (Mazzilli, 2011) 2.3.4 Corporate Bond Funds They invest in investment-grade domestic corporate debt instruments rated BBB or above. (Mazzilli, 2011) 2.3.5 Mortgage-backed funds They invest primarily in mortgage-backed derivatives or securities. Many of them are backed by government guarantees. Their earnings come from interest and from the amortization of principal. They are quite complex in their configuration. (Mazzilli, 2011) 2.3.6 Income Funds They mainly concentrate on current income with capital growth. These kinds of funds concentrate on High-dividend yield securities. They also prefer higher-yielding preferred stocks taxed as ordinary income in the hands of investor. (Mazzilli, 2011) 2.3.7 High Yield Bond Funds They concentrate on corporate debts rated below BBB. This makes them to earn higher income but they are subjected to higher risks. (Mazzilli, 2011) 2.3.8 Emerging Market Funds They invest mostly in emerging market government securities and corporate bonds. They also include sovereign bonds in their portfolio. At times, emerging market funds offer great opportunity for these countries are on the fast track of economic growth and in need of huge capital investments (Rahemtulla 2010). 2.3.9 Global Income Funds They invest in US and foreign government debt including corporate debt. They diversify across countries in their investment; however, they maintain majority holdings in US dollar-denominated securities. Many of them do carry currency risk. (Mazzilli, 2011) 3.0 Chances Offered by Close-End Funds Unlike open-end funds, fund managers need not maintain any liquidity or the cash flow to redeem the shares of the investors. Thus, any closed-end funds offer more opportunities to the fund manager as they can plan and manage the investments on long term basis to provide superior returns to the investors. In the same fashion, it offers great opportunity to the investors by buying these funds at deep discounts to the NAV from the wide variety of available funds. 3.1 Competencies of the Initiator or Fund Manager A common investor is always stuck with many limitations while making any investment decisions on its own as it is difficult for them to know about the development in the myriad of the industries at any given time. The other drawback that investors will encounter is that of their inability to diversify into a larger portfolio due to the constraints of smaller investment resource at their disposal. Usually, any closed-end fund will have large corpus for the investment and by deploying professional management and competencies of a fund manager, the fund can achieve better investment returns. (Mazzilli, 2011) 3.2 Participation in the New Projects with an Eye on Diversification Upcoming and promising new projects particularly in the field of high tech areas offer great opportunity for investments but individual investor cannot participate in that due to limited resource availability. The need is greatly fulfilled by the close-ended funds. Moreover, diversification strategy works best with close-ended funds due to availability of large size funds. The diversification strategy cannot be managed at an individual level of investors due to resource and time constraints (Understanding the advantages of closed-end funds 1999). 3.3 Investment with Clear Objectives Closed-end funds are available with variety of investment philosophies. Some of them are specialized in fixed income securities and some have better understanding of stocks. Some are geared for long term appreciation and some focus on current incomes by investing in higher dividend yield companies. Certain funds have better feel of overseas market and they earn more by investing in the specific country or region. Investors can choose from funds having different objectives and view point (Understanding the advantages of closed-end funds 1999). 3.4 Periodic Dividends or Distributions Certain close-end funds have regular distribution policies. If the investment is made from the view point of receiving current income then investment in such funds really help to meet individual objectives too. (Mazzilli 2011) 3.5 Tax Advantage Close-end funds are spared of paying taxes at their level on their distributions. This helps funds to increase distributions. This is certainly a benefit to the investors of the fund. (Mazzilli 2011) 3.6 Buying at a Discount The difference between open end fund and close-end fund lies in that open-end funds offer investment opportunity at Net Asset Value (NAV) of the fund; however, close-end funds offer opportunity usually at discounts to NAV. It has been commonly found that in the stock market, prices move as per the demand and supply dynamics of the share. At the higher demand, the price of the share of the fund may move close to the NAV of the fund (Understanding the advantages of closed-end funds 1999). 3.7 Possibility of Leveraging Closed-end funds may also leverage their investment positions by issuing debentures and borrowing money. This gives fund managers an opportunity to enhance yield and increase the return to the investors. This can be viewed as a market opportunity at an appropriate time. Many close-end fund managers as a matter policy do not indulge into leveraging to avoid undue risks; nevertheless, it can be seen as an opportunity available to managers during critical time. (Mazzilli 2011) 3.8 Smooth Portfolio Management The closed-end fund managers have relatively a stable pool of capital in their command. The reason is that there is no short term obligation on fund manager to manage cash flows as there is no pressure from investors to redeem their shares. Obviously, manager can work out more clearly a long term strategy to earn best possible returns from the available resources. Open-end fund manager does not enjoy such liberty. Thus, close-end fund manager can invest in securities which are though less liquid; however, offers a great promise in the long run. The fund manager can ignore the short-term fluctuations of the market and concentrate more on the underlying strength of the portfolio. Similarly, in a bull market fund manager is not flooded with the fund which must be invested at the prevailing prices. So to that extent close-end fund manager enjoys more liberty when compared with open-end fund (Understanding the advantages of closed-end funds 1999). 3.8 Lesser Expense Ratio Close-ended funds are much better placed in comparison to open-end funds as far as expense ratio is concerned. There is no frequent to and fro cash flows between the fund and investors; obviously, this results into lesser fund cost in distribution of the shares and redeeming the original investment. (Mazzilli, 2011) 3.9 Above Average Rates of Return The very basic fact that the closed-end funds are available at deep discounts, at times available at 20% discounts from the prevailing NAV, makes it superbly attractive. The above average return is observed when market bounces and funds start trading at lesser discount or near to NAV. This happens when economy takes U-turn and whole economic cycle is on upswing. This is in contrast to the open-end funds which mostly trade at NAV and investors do not find that kind of opportunity. (Understanding the advantages of closed-end funds 1999) 4.0 Risks All investments entail certain risks and that is also true for closed-end funds. Some funds by virtue of their types may have more of lesser risks in their investments; however, higher risks also offer higher rewards to the investors. Risks could be of several kinds depending upon the funds area of operations and investments. Some of the major risks in the operation of close-ended funds can be listed as per the following. 4.1 Risk of Liquidity Close-end funds may carry the liquidity risk in their investments in the sense that market may not absorb the buy or sell order in a given time frame and in a given lot size. Also lesser the liquidity means higher the spread (difference between buy and sell price) and to that extent transaction cost also increases. (Mazzilli, 2011) 4.2 Total Loss of Money If close-end fund has not diversified portfolio then it may carry the risk of total loss of its investment given that the project in which the fund has done major investment does not take off. In the case of close-end debt fund, if the issuer of bonds is unable to pay principal and interest payment, the fund will lose its total investment in that bond. 4.3 Liability or Credit Risks Liability or Credit risks relate with the creditworthiness of the bond issuer and their ability to pay timely interest payments whenever it falls due. Any decline in bond issuer's credit rating will have a bearing on the price of its bond and that will affect the share price of the funds that hold these bonds. (Mazzilli, 2011) 4.4 Problems with Initiators There are good funds and bad funds in the market and there are varied reasons for the funds that are not performing well in the huge market of investment business. Lack of experience or the competency of the initiator is quoted as the major fund specific reasons for their not performing well. Sometimes the conflict of interests could also be an underlying reason for the below average performance for some fund. 4.4.1 Lack of Experience/Competency Initiators of the funds may have several issues in the operations affecting the performance of the fund. In fact, in changing market scenario some of the old strategies do not work well. In a period of sustained growth, it is alright to invest in a particular share and then sell it two decades later at great profit. This model of investing is now losing its relevance. It has been reported that almost 3 million investors sold out mutual funds in 2010 and 2011alone. Stammer (2011) argues that though there are some exceptional financial managers, they are quite rare when viewed across several funds that are in the investment business. He is of the view that many fund managers lack required competency and that is the main reason for their funds not performing well. (Stammer 2011) 4.4.2 Conflicts of Interests Sometimes the closed-end funds are also afflicted with conflict of interests. This happens when CEO of the some fund is also a director of some other independent fund. For example, Frank Holmes is owner cum CEO of US Global fund and also a director in other funds. Weinberg and Lambert (2003) argues why the performance of US Global funds have been only mediocre. They further report that the US Global is a poorly governed, weak on disclosure and full of conflicting interests. (Weinberg 2003) 4.5 Interest Rate Risks Closed-end bond funds carry interest rate risks in the sense that a bond's price is closely linked with the market interest rates. When interest rates go down, the bond price may go up. Similarly, when interest rates go up, the bond price will go down. Bonds duration has a lot to do with interest risks as higher the duration or longer the remaining period of maturity, the more are the chances of interest rate risks. Longer-term bonds will have more fluctuation in value compared to shorter-term bonds. It is obvious that due to higher risks it is likely to give higher rewards too. It means that it will be available at higher discounts than the bond with lesser maturity period. Close-end equity funds do not have interest rate risks as their incomes do not depend upon fixed interest rates. (Mazzilli, 2011) 4.6 Prepayment Risk Sometime funds carry prepayment risks on their investments for bonds when they receive their principal investment back from the issuer entity prior to its maturity. This may happen when there is a substantial decline in the interest rates making it unattractive for the issuer to hold the debt at higher interest rates. It becomes more attractive to avail new loans at the lower interest rates and payoff the old ones engaged at higher interest rates. This happens mainly with callable bonds where issuer has the right to redeem the bond before its maturity date; however, this privilege does not come free and the issuer need to pay higher interest rates for availing right to prepay the bond at any future date. This kind of risk is largely found with mortgage-backed debt securities. Home mortgage bonds usually have high prepayment rates because homeowners prefer to pay their home mortgages when interest rates fall. That is also the reason home mortgage-backed bonds provide higher yield to compensate for this risk. (Mazzilli, 2011) 4.7 Inflation Risk The inflation risk is mainly applicable to bonds funds where earnings are in terms of fixed interests. Fixed interest earnings have negative impacts when inflation is on rise. They are good when inflation fairly remains at constant rate. For example, assuming $5,000 in a bond earns 6 percent interest rate and inflation rate is 2 percent throughout the period until maturity of the bond. This clearly gives 4 percent return to a bond holder net of inflation but in the same case if inflation rises to 4 percents, the effective return to the bond holder will fall by 2 percents. Longer the maturity period of the bonds means higher the inflation risk for the bond holder. The continued high inflation erodes the purchasing power of the investment and thus effective return. Though expectation of the inflation rate does compensate the bond holder in the bond yields yet at times, it surpasses the expected inflation rate causing the erosion in real value. (Mazzilli, 2011) 4.8 Currency Risk Certain close-end funds such as global funds who invest in overseas securities, stocks or bonds inherently carry currency risk. Any currency depreciation of the country in which the investment has been made will bring down the effective return in that ratio. For example, $100,000 invested in India during July 2010 would have got converted at the rate of Rupees 45 per dollar giving investment of Indian Rupees 4,500,000; however, after six months in order to get the same investment back in dollar terms ($100,000), fund need to have Rupees 5,300,000 as Indian rupee has depreciated substantially and currently it is getting exchanged at Rupees 53 per dollar. Thus, currency risk is prominent when the funds go abroad for investment. (Mazzilli, 2011) 4.9 Political Risk Funds investing abroad do have political risks too. Any change in political setup in the country where investment in the equity or bonds is made can jeopardize the investments and possible returns on the investment. These risks are usually observed where political setup has been unstable due to certain recent issues and where stable government is not at the helm of the affairs with clear policies. The recent political upheaval in Egypt is a case in this regard where EGX30 index has fallen from 7200 to less than half at 3587 in just one year. At time, these risks are huge and can wipe out the initial investments made in that country (The Egyptian Exchange 2011). Reference 1. Closed-End Funds (2007), retrieved December 29, 2011 from, http://www.sec.gov/answers/mfclose.htm 2. Closed-End Fund (2011), retrieved December 29, 2011 from, http://www.investopedia.com/terms/c/closed-endinvestment.asp#axzz1hn2Lnd4z 3. The Egyptian Exchange (2011), retrieved December 29, 2011 from, http://www.egx.com.eg/English/homepage.aspx 4. Stammers Robert (2011), Do Mutual Funds Still Make Sense, retrieved December 29, 2011 from, http://www.forbes.com/sites/cfainstitute/2011/12/28/do-mutual-funds-still-make-sense/ 5. 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Rahemtulla, K, (2010), Closed-End Funds vs. ETFs: Are You Missing Out On “Secret” Profits From Emerging Markets, retrieved December 29, 2011 from, http://www.investmentu.com/2010/March/closed-end-funds-vs-exchange-traded-funds.html Read More