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: a brief review
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.
CEFs, however, are structured very differently from OEFs. 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 OEFs, CEFs generally have a static number of shares outstanding and do not
issue or redeem shares to meet investor demand on a daily basis.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, CEFs 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 CEFs 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 CEF shares typically trade on an exchange, CEF shares fluctuate in price
throughout the day. OEF 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.
CEFs 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 CEF 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 CEF share price performance.
As a result of these influences, CEF 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 CEF’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 CEF 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 CEF 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 CEF
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 CEF 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, and the underlying asset class and sector exposures
as well as how it 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