Ethiopian Review

Closed end funds are often overlooked; investors often lose interest in closed-end funds after the initial offering. Like mutual funds, closed-end funds are a diversified collection of securities managed by a professional investment manager. Some closed-end funds have been in existence
for close to 100 years. The main difference is the discount or premium to NAV, use of leverage, lack of cash drag, and lower-management fees. Let look at each point further in detail.

Discount or Premium to NAV

When a price of a mutual fund is reported in the newspaper, this is the NAV (net asset value) of the fund. This is simply the value of all the positions divided by the number of units. The majority of mutual funds allow investors to buy or sell their units at this price daily. Closed-end funds are purchase like a stock from a stock exchange; investors cannot purchase or sell units from the manager. Closed-end funds managers communicate the NAV of their fund, but often the price paid for units on the stock exchange is at a discount or premium to the NAV. This can create an opportunity to obtain a collection of diversified investments at a discount. Many closed-end funds frequently trade at discounts of 20% or more from their NAV. Current discounts or premium to NAV’s can be found at the Closed-end Fund Association website www.closed-endfunds.com.

Use of Leverage

Mutual funds do not use leverage, some closed-end funds do. Leverage magnifies gains or losses; some closed-end funds use up to 50% leverage. In this case, for every $1 invested would control $1.50 of investments. The cost of leverage for a closed-end fund is most likely less than the cost of leverage for an individual investor. In other words, a closed-end fund most likely can borrow at lower-interest rates then an individual investor would be charged with a margin account.

Lack of cash drag

Mutual fund managers must maintain a portion of the fund in cash to support possible redemptions; this produces a cash drag. Cash drag produces a lower return on the fund due to the low-interest rate earned on the cash portion. Closed-end funds are fully invested since there is no chance
of redemptions.

Management Fees

The management fee of a closed-end fund is typically much lower than open ended mutual funds. Management fees of closed-end funds are generally less than one percent.

Instead of automatically buying a mutual fund or exchange trade fund, investors should consider closed-end funds. They can be particularly attractive if they are trading at a substantial discount to their NAV.

William McNarland, CFA has been working in the investment industry for 15 years. He is a co-founder of PMCMG Inc. and My Global Analyst Inc. He has appeared as a guest on Money Line and taught at the University of Toronto. He resides in Alberta Canada. He can be contacted at info@pmcmg.com.

- by William McNarland, CFA | AC