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A Closed End Fund (CEF) is an investment company which is listed on an exchange and traded intraday at prices determined by supply and demand in the market, similar to stocks. CEFs invest in a variety of securities and are actively managed by an investment management firm in accordance with the fund's particular investment objective and strategy. The investment strategies come in many varieties to meet specific investor needs and may involve the use of leverage and investments in illiquid securities. CEFs may be diversified or non-diversified depending on the fund's investment objective and strategy. Learn more about Closed End Funds.
Unlike open-end mutual funds which are continuously offered, CEFs raise a fixed amount of capital from investors (by selling a fixed number of shares at one time) through an initial public offering. Following the initial public offering, there are typically no more shares available from the fund sponsor and the issuance of new shares is "closed" to investors. Once issued, the fund itself does not issue or redeem shares daily. Rather, the fund's fixed number of shares are traded on an exchange such as the New York Stock Exchange (NYSE) or NASDAQ.
Following the initial public offering, there are a few ways CEFs can raise additional capital:
Stable capital base
Unlike open-end mutual funds, CEFs have a relatively stable pool of capital; because they are "closed", capital does not flow into them when investors buy shares or flow out of them to satisfy investor redemptions. Therefore the portfolio manager does not have to constantly invest in or redeem securities as funds move into and out of the fund (and does not have to maintain cash on hand to meet customer redemptions).
CEFs use leverage and can access illiquid securities or markets
A CEF can use leverage by issuing preferred stock or debt securities to raise additional capital which can then be used to buy more securities for its portfolio. Leverage achieved through the issuance of preferred stock or debt is referred to as "40 Act leverage" after the Investment Company Act of 1940 ('40 Act), which among other things regulates the amount of leverage funds can bear. CEFs invest the additional capital raised through leverage in securities whose return is expected to exceed the borrowing cost associated with the preferred stock or debt security. A CEF can also create leverage through certain investments held in its portfolio, such as reverse purchase agreements, tender options, bonds, derivatives or other instruments, referred to as "non-'40 Act leverage" because this type of leverage is not subject to the regulations of the '40 Act. In general, leveraging strategies are used to potentially enhance return for shareholders, but can also magnify losses. CEFs are also permitted to invest in illiquid securities such as emerging market securities, Master Limited Partnerships (MLPs), commodities, private equity/debt, etc. The introduction of alternative asset classes can help achieve greater diversification of the fund, but also involves increased risks.
Discount/Premium
The net asset value (NAV) of a CEF is reported by the fund at the end of the trading day and is based on the total assets of the fund, subtracting the total liabilities, divided by the total number of shares outstanding. The NAV will fluctuate with changes in the market value of the CEF's underlying holdings. The market price of a CEF is determined by supply and demand in the market and not by its NAV. The market price of a CEF will fluctuate throughout the day, and will often be different than the NAV. Shares may trade at a price that is higher than the NAV (a premium) or at a price which is lower than the NAV (a discount). Historically, CEFs have frequently traded at a discount to their NAV. Premium or discount is often reflected in percentage terms.
Distributions and Return of Capital
A CEF must make distributions of substantially all of its income to shareholders to receive favorable tax treatment under the Internal Revenue Code. Distributions from CEFs to shareholders generally come from the following sources:
Some CEFs have managed distribution policies which seek to provide a predictable, but not guaranteed, level of cash flow to shareholders. The distribution policy typically specifies that regular distributions be made (either a fixed payment or payment based on a percentage of a fund's assets, generally made monthly or quarterly).
If a CEF's distribution is not fully covered by investment income and net realized gains, the shortfall will be a return of capital. In this case, shareholders may be receiving their own capital back resulting in a reduction in the fund's capital base (a "destructive" return of capital). Return of capital can come from other sources including, but not limited to, unrealized capital gains ("constructive" return of capital) and pass-through income from master limited partnerships (MLPs). It is important for investors to not make assumptions or compute yield based, in part, on the fund's distributions without fully understanding the source of the distribution received.
Types of CEFs
In general, there are two main asset categories of CEFs - stock and bond. CEFs may be further classified based on specific attributes of the CEF. Fidelity uses CEF Asset Classifications provided by Morningstar®.
Morningstar ® CEF Asset Classifications
The following are general risk factors associated with CEF investing.
Market Risk – CEFs are subject to market volatility and the risks of their underlying securities which might include the risks associated with investing in smaller companies, foreign securities, commodities, and fixed income investments. Investment return will vary and an investor's shares, when sold, might be worth more or less than their original cost. CEFs with complex or specialized investment strategies may experience increased market price volatility.
The market price of a CEF may be significantly different than its NAV (a premium or a discount). CEFs frequently trade at a discount to NAV and there is no assurance a CEF will appreciate to its NAV.
Interest rate Risk – Income received from a CEF may fluctuate significantly based on changes in interest rates. As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities. For closed end funds that hold fixed income securities in their portfolios, the risk can be significant.
Credit Risk – Credit risk is the risk that the issuer of a security will default or unable to meet its obligations to pay interest or principal as scheduled. This is a significant risk for closed end bond funds as a default by one or more of the CEF's underlying bond holdings can have a significant impact on the CEF's NAV, market price and ability to make distributions to shareholders.
Derivatives Risk – The prices of derivatives' contracts are inherently volatile and even small price movements might result in large losses to the CEF.
Leverage Risk – The use of leverage can magnify price volatility and loss of principal in the CEF's portfolio. Fluctuations in interest rates will also have an impact on a leveraged fund's distributions as the cost of borrowing associated with the leverage will fluctuate in response.
Liquidity Risk – Although CEFs are listed and traded on an exchange, the degree of liquidity, or ability to be bought and sold, will vary significantly from one CEF to another based on various factors including, but not limited to, demand in the marketplace.
Concentration Risk – The degree of diversification varies significantly from one CEF to another. Certain CEFs may target a small universe of securities, such as a specific region or market sector. These CEFs are generally subject to greater market volatility as well as the specific risks associated with that sector, region, or other focus.
Foreign Investment Risk – CEFs that invest in foreign securities are subject to interest rate, currency-exchange rate, economic, and political risks. All of these risks are magnified in emerging markets.
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Before investing in any fund, you should consider its investment objective, risks, charges and expenses. Contact Fidelity for the most recent shareholder report for this information. Read it carefully. Please also review information provided by the fund on its web site.