Thursday, February 4, 2010

"Closed" Mutual Fund vs. "Closed End" Mutual Fund

One thing that I see a lot is that there are certain investment products that are marketed (and are consequently well-known) and that there are other investment products that are not marketed, or are marketed much less (and consequently are not very well-known at all.)  Unfortunately, in many situations the less-marketed investment product may actually be the better choice for some investors.  First, a note - this is not investment advice, just educational advice.

In this regard, I have had at least 3 lawyers in the past month confuse a "Closed Mutual Fund" with a "Closed-End Mutual Fund."  That's unfortunate because closed-end mutual funds can often provide an investor with substantially better returns - as we will discuss more below.

First, there are really two types of mutual funds - "open-ended mutual funds" and "closed-ended mutual funds".

Open-ended mutual funds are the typical mutual funds that you can buy at Vanguard or Fidelity, for example. How these funds work is that the mutual fund company initiates a fund by accepting investments from anyone who wishes to be a part of the fund.  Additional investments in the fund are also accepted at any time.  In summary, you send them your money and they buy stocks or bonds with it.  As more money comes in, they buy more.

However, open-ended mutual funds also have some drawbacks.  First, investors can typically redeem their investment at any time - and they often do so at the worst possible time, like during the market downturn last year.  Consequently, as the investment manager, you typically have to keep a percentage of the investments in cash and may be forced to liquidate a holding when it really hurts because you have to cash-out a withdrawal from the fund.  This is especially ironic because many mutual funds endorse "buy-and-hold" investing for their clients, but they are typically unable to do so themselves in their funds because capital is constantly going into and out of these funds.  There is also obviously a penalty in investment return associated with this.

At any point, a provider of a mutual fund may "close" the mutual fund - this does NOT convert the mutual fund to a "closed-end fund".  Instead, this just means that the mutual fund is limiting additional investments in the fund.  Sometimes it is a soft close where present investors can still buy more, but no new investors can buy in.  Other times it is a hard close where neither present investors nor new investors can buy in (although even with a hard close, they typically allow your dividends to be reinvested.)  When the fund is "closed", investors can still redeem their investments at any time.

Closed-End Mutual Fund
Turning now to a "closed-end mutual fund", the structure of the fund is much different.  Here, an investment company starts a fund by starting a corporation, funding it with an initial investment, and then offering shares in the corporation for sale.  For example, Nuveen may take $200M, fund a company with the $200M (let's call it "Nuveen Corporate Bond A" - or NCBA for short), then NCBA goes out and buys $200M worth of corporate bonds.  Finally, shares of NCBA are offered on an exchange.  The shares of NCBA trade like stocks - they effectively ARE stocks in NCBA.  New investors do NOT contribute to the $200M in the corporation - instead, they just buy some of the shares of NCBA.  Investors can buy and sell the shares at any time of the day - unlike mutual funds which only offer redemptions at the end of the day.

So what are the advantages?  Well, in the closed-end mutual fund, the investment manager can invest 100% of his assets and never has to worry about redemptions.  His $200M is never going to be touched - neither added to nor taken away from.  The investors just trade the stocks.  This means that closed-end funds almost always kick the ever-living stuffing out of open-ended funds.

So why aren't closed end funds advertised?  Frankly, there is no economic incentive for anyone to advertise.  The investment manager does not make any more money if more people trade in the stock - he is only judged on his investment performance, not the stock performance.   Conversely, in the open-ended fund, the more assets in the fund, the bigger the fee for the investment manager.

Additionally, because the $200M is fixed, it can often be partially or fully leveraged which can increase your return - although this is a choice of the individual fund.  Some funds use leverage and some do not.

How Big A Difference Are We Talking? Big.
Vanguard is a solid mutual fund company that is especially good at bond funds.  The easiest comparison is to compare bond fund yields.  Here's a table of Vanguard's funds. 

As of today, I note the following yields:
  • Tax-exempt long term bond - the highest yield is 4.04
  • Taxable investment-grade bond - the highest yield is 5.78
None of Vanguard's funds are leveraged. (Fair disclosure - I have an account with Vanguard, but Vanguard's returns are pretty indicative of the open ended mutual fund market.)

Now, turning to the Nuveen fund screener :

Searching for tax-exempt closed-end funds that have less than 10% leverage and no managed distribution (a managed distribution is where the fund seeks to keep the distributions level and may distribute capital if necessary).  I find five closed-end funds yielding over 6% - the highest of which is at 6.67%

Just to draw your attention to that - recognize that these are tax-exempt funds!  At a 33% tax bracket, a 6.67% tax-free return is really a 9.96% pre-tax return.  And that's without even doing anything fancy.  If you are willing to accept leverage of about 40%, there are actually two tax-exempt closed-end funds with yields over 8%.

These yields obviously kick the heck out of Vanguard's 4.04%.  If you are doing a more apples-to-apples comparison, the closed end fund yield of over 6% is 50% greater than Vanguard's yield.  Further, if you are willing to accept some leverage, you can actually double Vanguard's yield.

Similar things happen with investment grade bonds - closed-end funds with less than 20% leverage and no managed distribution can get you four funds yielding over 9%.  Allowing more leverage (but still less than 50%) provides you with 6 funds yielding over 10%.

Of course, you will want to do your homework a lot more before investing in closed-end funds.  (There are more variables to be aware of - for example, the stock price may trade at a discount or premium to the value of the assets.)  However, all lawyers should be aware of closed-end funds - they can really work out very well (and I can speak from experience), but they are not advertised much if at all.                                                                                                    


  1. This is incredible. I've read countless articles on investing, which generally come to the same conclusion: For 99% of people, index funds are the way to go. None of them even ADDRESSED closed end mutual funds, let alone compared the two. There's so much more to learn! Thank you again for a great post.

  2. 10:57 - Thanks for the comment! However, you are confusing a fund type (closed) with an investment style (index). You can buy index funds as closed-end mutual funds rather than open-ended mutual funds (the closed-end mutual funds are commonly called ETFs -exchange traded funds- in this context). For example, you can buy the SP500 as an open-ended mutual fund through Vanguard (for example) or you can buy SPY or IVV like stocks - they are ETFs that track the SP500. Either way, you are still buying the index, it's just whether you are going to be on the hook for people's poor trading decisions as the open-ended fund has to liquidate assets when people want to cash out.

  3. I was switching to personal financial advising since it's what I did before law school. Not familiar with these, I'll have to keep them in mind. The discount thing is what's making it so attractive I think.

  4. Hi David - Certainly the ability to buy the fund at a discount to its NAV can be attractive. Also, the discount aspect is going to be more interesting if you are a short-term trader because it can add to the volatility of the underlying fund. However, from a buy-and-hold perspective, a 10% discount to NAV seems like it has less of an impact than a 50% increase in yield.