How should investors in closed-end mutual funds judge performance? These vehicles are more complex than conventional open-end mutual funds. And because of that, measuring performance is a bit more complicated.
Closed-end versus open-end funds
Closed-end funds (CEFs) differ in significant ways from open-end funds (OEFs). Both have important, but distinctive, roles to play in a diversified portfolio and evaluations of CEF performance need to take into account notable differences in structure and pricing, as compared to OEFs.
Like OEFs, CEFs offer investors a convenient and cost-effective way to invest in a professionally managed portfolio, reflecting a specific investment objective. Both types of funds may provide the potential for generating income and capital growth through investment performance and distributions.
Closed-end funds, however, are structured very differently from open-end funds and because of that, they may provide certain unique benefits, including more flexibility in the use of leverage and potentially greater access to less liquid, but potentially higher-yielding segments of the global markets.
Unlike open-end funds, closed-end funds generally have a static number of shares outstanding and do not issue or redeem shares to meet investor demand on a daily basis. Footnote 1 Furthermore, CEF shares typically trade on an exchange. Like other publicly traded securities, the market price of CEF shares fluctuates and is generally determined by supply and demand in the marketplace, among other factors.
In significant part due to the closed-end fund structure, closed-end funds have greater flexibility to use leverage in seeking to enhance return potential and often offer higher levels of current income compared with OEFs with similar investment strategies.
And, because closed-end funds do not need to manage unpredictable inflows and outflows of fund assets like OEFs, they enjoy a relatively stable pool of assets. This not only helps facilitate the use of leverage, but also allows the funds to attempt to take advantage of attractive, less liquid and potentially higher-yielding securities.
Because closed-end fund shares typically trade on an exchange, CEF shares fluctuate in price throughout the day. Open-end fund shares, on the other hand, are generally priced once every business day based on the fund’s net asset value (NAV) per share at the close of business on that day.
Closed-end funds also have an NAV that is calculated daily. NAV is important because it reflects the value of net assets held in a portfolio. But because a CEF’s share price is determined based on market forces, as discussed above, rather than NAV, the market price of CEF shares is often not the same as its NAV.
As mentioned earlier, the market price of closed-end fund shares fluctuates subject to the forces of supply and demand. While changes in market price will bear some relation to changes in NAV, market price may also be influenced by everything from a fund’s yield relative to similarly-focused CEFs to investor sentiment about the broader market and economic outlook or conditions in a particularly relevant sector. Demand for or aversion to levered investments may factor in, as may manager popularity.
The release of new fund information may affect closed-end fund share price performance.
As a result of these influences, closed-end fund shares can (and typically do) trade at a discount or premium to a fund’s NAV.
Significance of a discount or premium price
The relationship between a closed-end fund's market price and its NAV is often referenced as one measure of fund performance. A fund is said to be trading at a discount when its market price falls below its NAV; if the market price rises above the NAV, the fund is said to be trading at a premium. But, neither premium nor discount pricing in and of itself tells a complete story.
For example, a closed-end fund trading at a discount, depending on the supply/demand forces mentioned above, could be an indication of a value opportunity. Or, it may reflect the market’s estimation that the fund’s future earning or distribution potential could be at risk. It could also reflect changes in market sentiment and the view that certain asset classes or sectors of the market may be out of favor.
Likewise, a closed-end fund trading at a premium could be a sign the market has high regard for the fund’s portfolio management team and sees a strong probability its share price will continue to appreciate. But, it could also mean the fund is currently overvalued.
Alternative measures of performance
There are divergences of opinion on how best to evaluate closed-end fund performance. Performance may be measured as a percentage change in the market price or the NAV, including or excluding distributions. PIMCO believes a CEF’s total return on net asset value, including fund distributions, is one of the most important indicators of a portfolio manager’s ability to add value.
A competitive yield or distribution rate can have a positive impact on a closed-end fund demand and, thus, may favorably influence a fund’s market price. Steady monthly or quarterly dividends often are the key selling point for CEFs. However, it is critical to look at distributions in the context of a fund’s earning profile, as the board of a fund may change distributions from time to time depending on how the fund’s earnings profile changes. CEFs typically report information about their earnings in shareholder reports and other updates. Shareholders should consult these reports to better understand the earnings profile of a specific fund in relation to its distributions.
Before investing in a closed-end fund, it is important to review its trading history, performance, current earnings in relation to distributions, underlying asset class, and sector exposures, as well as how the CEF may complement other elements of a portfolio. Without question, CEFs are a bit complex; and they tend to be more volatile and have portfolios that are less liquid than conventional open-end funds. At the same time, they can be an important source of income and enhanced return potential for sophisticated investors.