Closed End Funds
Frequently Asked Questions About Closed end Funds and Their Use of Leverage
What are closed end funds?
Closed end funds are professionally managed investment companies. Closed end funds differ from other types of investment companies because, like publicly traded operating companies, closed end funds issue a fixed number of shares which typically are listed on a stock exchange. Once issued, closed end fund shares are not typically purchased or redeemed directly by the closed end fund, but instead are bought and sold in the open market. The closed end fund's common shareholders own these shares.
What types of securities do closed end funds invest in?
Closed end funds invest in a wide variety of securities, including common stocks, preferred stocks, high-yield bonds, municipal bonds, and foreign securities.
How many closed end funds are there?
As of the end of December 2007, according to ICI data, there were 668 closed end funds with more than $314 billion in assets.
What type of shareholder protections do closed end funds offer?
Closed end funds are governed by the Investment Company Act of 1940, a law that shapes how all publicly offered funds must be structured and operated. All closed end funds therefore must meet certain operating standards, observe strict anti-fraud rules, and disclose complete information to investors. These laws are designed to protect investors from fraud and abuse.
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What types of stock do closed end funds issue?
Closed end funds all issue common stock. In addition, under Section 18 of the Investment Company Act of 1940, closed end funds are permitted to issue one class of preferred stock. Preferred stock differs from common stock in that preferred shareholders are paid dividends but do not share in the gains and losses of the closed end fund. According to ICI data, as of December 2007, 347 closed end funds issue preferred stock.
Why do closed end funds issue preferred stock?
Issuing preferred stock allows a closed end fund to raise additional capital, which it can use to buy more securities for its portfolio. This strategy, known as "leveraging," is intended to allow the closed end fund to produce higher returns for its common shareholders. Closed end funds can also leverage by borrowing money or issuing debt securities. Closed end funds invest the additional capital raised through leverage in securities that are expected to earn a rate of return that exceeds the short-term borrowing cost of the preferred stock or other leveraging instrument. The additional income, or "spread," is then available for the benefit of common shareholders of the closed end fund.
Is leverage commonly used by closed end funds?
According to data reported by Thomas J. Herzfeld Advisors, Inc., a firm devoted to research, analysis, and investment in closed end funds, 71 percent of closed end funds used some form of leverage in 2007.
Does the use of leverage by closed end funds present any risks?
Yes. The net asset value of the common shares and the returns earned by common shareholders in a leveraged closed end fund will be more volatile than those of common shareholders in a closed end fund that does not use leverage. In addition, if short-term interest rates rise, the cost of leverage will increase, most likely reducing the returns earned by the closed end fund's common shareholders.
Where can I find more information on closed end funds?
Additional information about closed end funds can be found at the Investment Company Institute's public website. ICI has prepared a guide about investing in closed end funds and tracks the assets of the closed end fund industry.
In February 2008, the Investment Company Institute posted on its website a discussion of closed end funds, from which the above was reproduced.