FINRA issued an investor alert this week titled "Closed-End Fund Distributions: Where is the Money Coming From?" in which it discusses the difference between a closed-end fund versus a traditional mutual fund and concludes with important questions to ask before investing. FINRA also points out the key pitfalls of the closed-end fund's advertised distribution rate, which may appear generous, but instead carries different implications than a fund's return.
While traditional mutual funds are professionally managed collective investment vehicles which continuously sell and redeem shares, most closed-end funds, which are similarly collective investment vehicles, instead offer only a fixed number of shares in an initial public offering (IPO).
As a result, closed-end fund IPOs are associated with premium fees and expenses that take away from the bottom-line investment: for instance, contributing $10 toward a closed-end fund likely will produce an actual investment of less than $10.
Closed-end funds also have historically traded at a constantly fluctuating market price lower than the associated fund's inherent net asset value while mutual fund shares are always priced based on this value, set daily.
Closed-end funds are additionally not impacted by redemptions while mutual funds are and closed-end funds portfolios are allowed to hold a greater proportion of illiquid securities, compared to mutual fund percentages.
When it comes to distributions, closed-end funds generally pay monthly or quarterly, increasing or decreasing the distribution rate from one period to the next and sometimes including a return of principal or capital within its managed distribution. These funds therefore carry higher risk because by returning capital to investors each distribution period, the fund's asset base decreases— closed-end funds can include a return of capital within distribution rates.
Meanwhile, traditional mutual fund generally produces a certain interest+dividend income yield figure, which is a different measure than the closed-end fund's distribution rate.
Prior to investing in a closed-end fund, FINRA recommends investors ask the following questions:
>> Does it fit within investment objectives? Before any investment, it is prudent to consider whether the investment's duration and level of risk fit within an investment profile—this goes doubly so for alternative investments. Note that volatile or illiquid investments frequently carry more risk.
>> What is the fund's investment strategy? Closed-end funds release annual or quarterly reports just like other funds and similarly, it is important to research the strategies used, along with risk, proposed distribution sources and other costs. Look for the word "leverage." That word means the fund manager is playing with borrowed money to juice the performance of the fund. Leverage can increase returns, but is often devastating when the market turns against the closed-end fund.
>> What is the sales charge—how much of an investment is actually invested? IPOs may include a built-in sales charge of nearly five-percent of its price, in addition to offering expenses.
>> How does the fund set its distribution rate? Frequent returns of capital suggest that a closed-end fund is unable to generate enough income to fund distribution; also playing into the riskiness of the fund, a current distribution rate is not indicative of future rates.
>> Are shares trading above or below the net asset value? This will indicate how the price you pay compares to the fund's inherent value; it also indicates how it will affect your total return.
If you have invested in a closed-end fund with a broker which has proven harmful to your investments or interests, please call The Law Offices of Jonathan W. Evans & Associates at (800) 699-1881 for a consultation.