Open end funds are a pretty standard type of investment, which include things like mutual
funds and index funds. Closed-end funds are a less common investment,
but they offer some pretty significant advantages because they are typically able
to offer higher returns and higher yields than funds in the open-end category. In this video,
we’re going to take a look at the key differences between closed end and open end funds in order to
determine which of these is a better investment for investors like you and me. Let’s get started.
Open End Funds Explained So first, let’s start with the
characteristics of an open end fund so we can properly compare the qualities of each type of
investment. Open-end funds are named because they are always open to and accepting new investments.
What this means is that mutual funds and ETFs that are in the open-end category
are able to continue issuing new shares as new investors become interested in the fund.
For this reason, the number of shares that an open end fund can issue is essentially unlimited.
Take VOO for example, which is an open-end ETF from Vanguard that tracks the S&P500
index. The roughly 520 million outstanding shares represents $160 billion of assets.
But let’s say demand increases and there’s $2 billion of additional demand for VOO.
Instead of this demand driving up the price of the fund, Vanguard simply issues additional
shares and lumps those $2 billion in with the rest of the fund’s assets.
So with open-ended funds, the pool of money that is actually being invested into stocks
is variable. This can be a good thing for funds like VOO which are designed to track
the performance of a certain index, because it can minimize some of the volatility that
comes from market pressure and demand. It keeps the price more in line with NAV,
or net-asset value, which is the market value of all of the assets in the fund.
Now VOO is technically an open-end fund in the way it's designed, but as an ETF, it doesn’t trade
like a true open-end fund. This is because most open-end funds don’t actually trade on exchanges.
You typically purchase open-end fund shares directly from an investment
firm like Vanguard or Fidelity. And this brings us to the primary downside of open-end funds.
Because open-end funds traditionally don’t trade on exchanges, you have to buy them and sell them
directly from the investment firm. This means the investment firm must hold enough cash on hand
to meet whatever demands that investors have. Basically, if a bunch of investors decide they
want to sell the shares of their open-end fund, in a process that’s called “redeeming” shares,
the investment firm has to have enough cash to pay for all of those shares. In order to
be prepared for that, a certain portion of the fund’s assets will be kept in cash at all times.
And this is the issue - because not all of the assets of an open-end fund will be invested.
I couldn’t find a clear answer on this, but it seems like most funds keep from 5 to 10%
of their assets as cash. So this means for every dollar you’re investing into an open-end fund,
only 90 to 95¢ is actually being invested. This will effectively reduce the returns
you see from your investments because not every dollar is being put to use.
So let’s take a look at how this differs from closed-end funds.
Closed End Funds Explained As you might have guessed by now, a closed end
fund is not open to new investments. A closed end fund raises all of its capital for its investments
through an IPO when it is created. Once this happens, there are no additional shares issued.
This makes closed end funds very different because you can’t just buy them directly from
the investment firm that manages the fund. You can only buy shares of closed end funds on exchanges.
Similarly, the investment firm is not responsible
for buying those shares from you when you want to sell.
When you want to cash in on your investments, you’ll have to sell them on an exchange.
Since the closed end fund does not have the responsibility to buy your shares,
they don’t have to keep cash on hand like an open end fund. For this reason, closed end
funds often have 100% of their assets actively invested, which means they can theoretically
generate higher returns than an open-end fund that is invested in an identical portfolio.
But these characteristics also have added
benefits for investors who are interested in closed end funds.
First of all, since shares of closed end funds can only be purchased on an exchange,
they are entirely vulnerable to the effects of market supply and demand.
This means that the market price of a closed-end fund is rarely identical to the price
of the underlying assets, or NAV. Shares often trade at a premium or a discount to the NAV.
I personally think this is really cool because you can theoretically buy a share of a portfolio
of investments for less than it would cost you to replicate that portfolio. And the possibility
of getting the underlying investments at a discount is a big advantage of closed-end funds.
The second benefit comes back to the fact that closed end funds don’t have to keep cash on hand.
They never have to worry about an investor coming back to them to redeem shares,
so they can be much more creative or unconventional with their
investments. They don’t have to worry as much about investing in liquid assets, because
it’s highly unlikely they’ll need to liquidate any holdings on short notice. And ultimately,
this means they’ll be able to make investments that open end funds wouldn’t have access to.
And this is another component that helps them generate higher returns than an open end fund,
because they simply have more options.
Another interesting aspect to this is that a closed end fund can’t raise more capital
to acquire new investments. An open end fund can continue to attract new
investors and use their capital to expand the portfolio, but a closed end fund has
to entirely rely on their performance to continue growing the portfolio. I think
this is exciting because they have to be that much more responsible with their strategy,
but it can also easily be a bad thing if the fund managers are irresponsible or unsuccessful.
So let me quickly summarize the differences between closed end funds and open end funds
and then we’ll get into some of the specifics of what to look out for
when making these kinds of investments.
Open end funds are always accepting new capital. Closed end funds raise capital once,
during an IPO, and do not gain any additional capital in the future.
Open end funds are bought and redeemed directly from investment firms. They have to keep cash
available so that investors can redeem their shares at any time. With the necessity of having
cash on hand, open end funds cannot invest 100% of their assets. This means slightly lower returns.
Closed end funds are bought and sold exclusively on exchanges. They have no
liquidity obligations to investors, and this means they can invest 100% of their assets,
and can invest them in more illiquid assets that open end funds cannot invest in.
Open end funds are often priced at NAV,
while closed end funds can trade at a discount or premium to the NAV.
So as you can see, closed end funds can offer higher returns and at discounted
prices compared to what you can expect from an open-end fund.
But this doesn’t automatically make any closed end fund a better investment than an open end fund.
So before you dive in, let’s take a look at some important qualities of closed end funds.
In my opinion, there are four main categories that I want to look at before investing in
a closed-end fund. And these four things are the diversification of the underlying assets,
any leverage or debt that the fund is using,
costs or fees associated with the investment, and the tax consequences
associated with holding the investment, particularly when it comes to dividends.
So with any fund or ETF investment, the first thing I want to look for is diversification.
It’s fairly common knowledge that diversifying your investments is the safest way to protect your
portfolio from any disasters. Now any closed-end fund will obviously be more diversified than an
individual stock, but there are many closed-end funds that focus their strategies on a particular
market sector, like Real Estate, while others focus on a specific type of underlying investment,
like MLPs or municipal bonds. None of these are necessarily a red flag to begin with,
but if you’re going to invest in a closed-end fund, you have to make sure you understand what
exactly they’re investing in. Otherwise, you might find your portfolio overweight in a certain asset
class or industry. Similarly, it’s important to understand what a closed end fund invests in so
that you understand where their profits come from. If they’re offering a 10% yield, you’ll want to
make sure their investments support that yield or else they might just be selling their assets - and
therefore decreasing their capital and the fund’s NAV - to fund distributions to investors.
The next thing you want to look for is a fund’s use of leverage. Since these funds can’t raise
any more capital from investors, one of the only ways they can get more cash is to borrow it.
Closed-end funds are legally capped at a ratio of 33% leverage when it comes to debt.
This means for every dollar in the fund, they can borrow no more than 33¢.
Leverage isn’t necessarily a bad thing, because it can be a great way for a fund to generate even
more profits for investors without having to have more capital. But, leverage does make a portfolio
more volatile. So you might see these funds react significantly to drops in the market.
Also, the interest from any borrowed money will be passed onto you through expenses and fees.
So you have to be careful when you see funds that are highly leveraged.
And that brings us to the costs and fees associated with closed end funds. Like I said, you
can expect any leverage in the portfolio to result in an added fee for you as an investor. This is
listed as “interest expense”. Additionally, you’ll pay management fees, which can be pretty high
considering that all of these funds are actively managed. Management fees of any percentage can
add up over time, so you really want these fees to be as low as possible. And this is a rule I
stick to with most investments, but I’m actually a little more lenient on fees from closed end funds,
and here’s why. Fees come out of the funds NAV, or net asset value. But closed end funds are unique
because they often trade at a discount to that net asset value. So from my perspective, if a fund has
fees of 2%, but it’s trading at a 10% discount, I’m still getting the underlying assets in my
portfolio at an 8% discount. Of course, that also assumes the fund is only temporarily at a
discount, and there are certainly some funds out there that are perpetually discounted,
so that’s just something to think about as you’re looking into specific closed end funds.
And finally, you have to consider the tax consequences of these funds.
Many closed end funds are designed around income producing strategies. This is great because you
can get really high dividend payments, you just have to take a closer look and make sure the
dividends you receive are going to be taxed to your benefit. Like I touched on earlier, there
are many funds that focus on municipal bonds, which provide tax-free income. Although, these
investments are really only beneficial to people in really high tax brackets, and I actually made a
whole video about municipal bond investing if you want to learn more about that. But for the rest
of the closed end funds out there, they’re going to produce taxable income. So the dividends that
you receive from these funds will either be taxed at your income tax rate, or at the capital gains
tax rate. Obviously, you want to make sure they’re taxed at the capital gains tax rate because that
is what is going to cost you the least in terms of taxes. But, there’s one other element here
in the event that a fund isn’t generating enough profit to pay you those dividends.
Some funds are categorized as “managed distribution” funds, which means they have a
target distribution rate that they try to deliver on every month or every quarter. The problem is,
if the fund doesn’t generate enough money, they still want to be able to provide that target
distribution rate. In these cases, the fund will actually sell some of its holdings and give them
to you as a “return of capital”. These aren’t taxed immediately, which sounds good at first,
but there are two problems with this. First, a return of capital reduces the cost basis of your
shares. This means that when you sell your shares in the future, your profits on that investment
will be calculated using the price you paid for the share initially minus all of the “return of
capital” you received. When this happens, you will end up being responsible for paying capital
gains taxes on all of the distributions that you previously received that were an untaxed return of
capital. Simply put, you might be responsible for a larger tax bill than you anticipated when you
sell your shares, so it’s important to be aware that this might be happening. The second problem,
which is just as concerning, is that when the fund can’t afford your distributions,
they’re selling their assets to be able to pay you. This is not sustainable, because if this
continues to happen, the fund will eventually run out of assets and money. So while the tax
situation can be manageable, you really want to make sure the fund isn’t relying on this “return
of capital” to pay you, because it can be a red flag when it comes to the longevity of the fund.
I hope all of this gave you a better understanding of the world of closed end funds.
I’ve been learning from John Bogle and telling myself for months that actively managed funds
are dangerous - but I think closed end funds are one of the few actively managed fund types
that I might actually be interested in investing in. The fact that they trade at a discount so
frequently and are able to produce much larger distributions than other investments makes them
very attractive to me as a dividend investor. Let me know what your thoughts are on closed end
funds after watching this video, because I’d love to discuss it with you in the comments.
And I know we didn’t take a look at any specific closed end funds today,
but don’t worry. Next week I’m going to use everything we talked about today to find the
best options when it comes to closed end funds, with the primary goal of finding affordable,
reasonably priced funds that offer capital growth and competitive dividend distributions.
So if you are interested in seeing that, make sure you subscribe to the channel so you don’t miss it.
Best of luck with your investments and I will see you in the next video!