Closed-end funds

General characteristics

Closed-end management companies are fairly similar to open-end management companies. The most significant difference is how they’re bought and sold by customers. Otherwise, both invest pools of money according to each fund’s objectives and goals in hopes of investment returns.

Closed-end funds are traded between investors in the secondary market, not with the issuer. When an issuer creates a closed-end management company, they construct a prospectus and sell the shares as an initial public offering (IPO). Once the shares are sold and the issuer collects the IPO proceeds, the fund’s shares trade in the secondary market between investors. Therefore, closed-end funds are negotiable securities. Like most negotiable securities, a fixed (closed-ended) number of shares trade in the secondary market. This represents a different type of capitalization as compared to open-ended (mutual) funds, which maintain a varying number of shares outstanding.

During the IPO, the prospectus rule applies. Every purchaser of a share during the IPO must receive a prospectus, which provides detailed information on the issuer and the security being sold. Once closed-end fund shares have been sold, delivering a prospectus is no longer required.

Sales charges do not exist with closed-end funds as they trade in the secondary market and are subject to commissions (just like stocks and bonds). In test questions, you can utilize this knowledge to answer questions correctly. Knowing mutual funds are subject to sales charges and closed-end funds are subject to commissions is an important concept for the Series 66 exam.

Because closed-end funds are traded in the secondary market, they can be purchased on margin (with borrowed money) and sold short. Stocks and bonds can also be purchased on margin and sold short as well, while mutual funds cannot.

Closed-end funds maintain net asset values (NAVs) just like mutual funds. In both circumstances, the NAV reflects the value of the assets held in the portfolio. However, it serves a different purpose with closed-end management companies.

We learned NAV is the foundational price for a mutual fund in the previous chapter. If a mutual fund does not have a sales charge, customers buy and sell their shares at the NAV. If there is a sales charge, it’s tacked on top of the NAV. Essentially, the cheapest price a mutual fund could be purchased for is its NAV.

With a closed-end fund, the NAV only serves as a guide for its market price. The shares trade in the secondary market, which is subject to price fluctuations based on demand. If there is an influx of purchases for a closed-end fund, the price will rise even if the NAV does not. Conversely, if there are a significant amount of sales of a closed-end fund, the price will fall even if the NAV does not.

NAV acts just like Kelley Blue Book does for cars. Let’s say you plan on selling your car and find your car listed for $10,000 in Kelley Blue Book. Your car may have a “book value” of $10,000, but the market will ultimately determine how much you sell it for. If there’s more demand for your car, you could sell it for more than $10,000, and vice versa. NAV works the same way for a closed-end fund.

The market price for a closed-end fund can be higher, lower, or the same as the NAV. In the end, the demand in the market will determine its price.

Interval funds

Interval funds are an interesting and unique type of closed-end fund* that share some characteristics of open-end funds. Unlike a typical closed-end fund, these funds are not traded on the secondary market. In many ways, interval funds operate like redeemable mutual funds. Investors purchase shares directly from the issuer at NAV. Oftentimes, a sales charge is assessed on top of the NAV.

*Although many aspects of interval funds line up with open-end funds, they are legally structured as closed-end management companies. Don’t worry about the specifics, just know what category of investment company they fall into!

Investors can redeem shares at a later date, but only at “specific intervals.” Known as a repurchase offer, most interval funds only allow redemptions to occur monthly, quarterly, semi-annually, or annually. For example, an interval fund with quarterly redemptions would only allow its investors to redeem their shares at four points in time during the year. At any other time, investors are unable to liquidate their shares.

Interval fund managers also place limitations on the number of shares they redeem at the intervals offered. In most cases, these funds will not allow more than 25% of the outstanding shares to be redeemed at any repurchase offer period. In the event that more shares are requested to be redeemed than the fund manager is willing to repurchase, redemptions are typically allocated on a pro-rata basis. For example, assume two investors request to redeem 10 shares each (20 total), but the fund is only willing to repurchase 16 total shares. Each investor would be allowed to redeem 8 shares each.

Due to this redemption structure, interval funds are known for their liquidity risk, making them unsuitable for investors needing easy and quick access to their money. Additionally, many interval funds assess redemption fees (also known as repurchase fees) of up to 2%. Thankfully, relevant rules and regulations do not allow redemption fees above this amount.

Sales charges and redemption fees are not the only costly concerns an investor faces with interval funds. They are additionally notorious for high expense ratios (due to significant management fees) and 12b-1 fees. Bottom line - an investor faces a number of costs associated with investing in interval funds.

Given all the risks and costs of these funds, why would anyone consider making an investment? While the “lock-up” nature of interval funds seems like a drawback, it provides the fund manager more flexibility. Instead of worrying about daily redemptions (like open-end fund managers do) or unhappy investors liquidating their shares in the market (like typical closed-end fund managers do), interval fund managers know their investors’ money is stuck in the fund for at least some time. This allows the manager to place investor funds into less liquid and more risky investments offering higher yields without pushing shareholders to sell their investments (because they can’t). As you know by now, more risk comes with more return potential! Regardless, an investor must weigh the returns of the fund against all costs and risks to determine if it’s a good fit for their portfolio.

If you’re curious and want to study a few real-world versions of this type of fund, check out Pimco interval funds.