One of the lesser known financial products available to Canadian investors is closed-end funds. In common with other investment funds, a CEF pools client money and invests fund assets according to specific objectives. While sharing the name "fund" with mutual funds and exchange-traded funds, these products have their own unique set of characteristics.
The average open-ended mutual fund is set up as a trust that issues as many units as needed to meet investor demand. The trust buys and sells these units directly. Investors can usually purchase or redeem units on demand at their current (NAV) with the price determined at the end of every trading day.
A CEF, on the other hand, is structured as a public company that, like ETFs, issues common shares that can be bought and sold on a stock exchange throughout the trading day. To buy a CEF, an investor must have a brokerage account and pay a commission for each transaction. According to Ken Kivenko of canadianfundwatch.com, small purchases of CEFs may not be economical due to brokerage fees.
Unlike ETFs, a CEF issues only a fixed number of shares. After the initial public offering (IPO), these shares can only be bought or sold on a stock exchange. The share price usually decreases after the IPO because of the underwriting fees incurred to launch the fund. In fact, many CEFs normally trade at a discount to their net asset value in part because they are not widely advertised to the investing public. Some financial advisers do not recommend CEFs to clients because, unlike many mutual funds, CEFs do not pay a trailer fee to advisers.
CEF managers have a stable pool of capital that they can invest fully. They are not forced to keep a cash reserve or sell stocks they want to keep in order to fund shareholder redemptions. For this reason, returns should be better than for similar open-ended funds.
In an effort to increase profits, some CEFs use investing strategies such as leverage i.e. they borrow money to invest or issue securities such as preferred stock. This creates the potential for bigger returns, or bigger losses. Leverage costs can significantly raise management expense ratios which otherwise tend to be lower than open-ended funds with similar investment mandates.
There are 180 closed-end funds in the Globe Investor Funds data base. Canadian investors can also buy U.S.-based closed-end funds which offer greater product choice (more than 600 funds) and lower MERs. The Closed-End Fund Association is a helpful source of information on closed-end funds listed in the United States and some Canadian-listed funds as well.
Some CEFs have broad equity mandates. For example, TSX-listed Canadian General Investments, Limited (CGI), one of the oldest closed-end funds in North America, invests primarily in Canadian corporations.
Another type of CEF specializes in splitting off the income stream from one or more dividend-paying stocks (often financials or utilities) to create two types of CEF shares:
- Lower-risk preferred shares yielding a return based on the dividend income of the underlying investment.
- Higher-risk capital shares with returns linked to share price changes and increases in the dividends.
Still other CEFS have very specific mandates, for example investing only in preferred shares, REITs, gold bullion, oil and gas, uranium company stocks or municipal bonds.
Shopping for a CEF is similar to buying an actively managed mutual fund. The fund mandate, manager, holdings, performance history, and fees should be examined. The fund price compared with its NAV is also important. Mr. Kivenko recommends that investors buy when a CEF is priced at a historically large discount to NAV. They could then reap additional profit if the price discount shrinks or even becomes a premium.
Fixed-income CEFs trading below net asset value are particularly attractive because they pay out the income from the underlying assets regardless of the current share price. This effectively delivers a higher return rate than an equivalent open-ended fund. Investors will need to shop State-side for a decent selection of fixed-income CEFs.
A significant number of CEFs trading on the TSX are fairly illiquid, trading fewer than a thousand shares daily, on average. This makes them better suited for buy-and-hold investing, although traders could profit during adverse market conditions.
Gail Bebee is the author of No Hype - The Straight Goods on Investing Your Money
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