Definition

A closed-end fund is a form of mutual fund that issues a set number of shares via an initial public offering (IPO) to raise funds for its initial investments.

Description

The demand for closed-end funds stems from their capacity to provide investors with access to a diverse portfolio of securities managed by professional fund managers, as well as the opportunity for capital appreciation and income creation via dividends. 

Closed-end funds can give liquidity and flexibility in investing options, making them ideal for investors looking for specific investment strategies or niche markets.

Like many other mutual funds, a closed-end fund is managed by a professional who buys, sells, and holds assets.

Like stocks and ETFs, its shares vary in price throughout the trading day. However, the closed-end fund's parent company will not issue additional shares, and the fund will not buy back shares—unless the closed-end fund is an interval fund, which can buy back shares.

Closed-end funds and open-end mutual funds share many similarities. Both distribute income and capital gains to their stockholders and have an annual expense ratio for their services. Furthermore, the companies providing them must be registered with the Securities and Exchange Commission (SEC).

 

Open ended fund vs Closed ended fund

For closed end funds pricing is the unique characteristic. Let us see the difference between Open end funds and closed-end funds 
 

Why are close ended mutual funds important?

Read here to know why closed ended funds make a difference:

High Stability For Fund Managers

In a close-ended mutual fund, investors cannot redeem their units before they mature. This distinct feature ensures a high level of stability for fund managers. With a predetermined asset base and no need to maintain liquidity due to the absence of redemptions, fund managers can focus on adopting successful strategies to achieve the scheme's investment objectives.

The Market Price is based on Supply and Demand.

Like equity shares, a close-ended fund's units can only be traded on the stock market, and their prices are determined by the scheme's supply and demand. When demand for a certain closed-end mutual fund scheme rises, supply will remain limited. As a result, its units will be sold at a higher price than the scheme's net asset value.

They aren't Illiquid

Close-ended mutual funds provide numerous possibilities for purchasing and selling units on the stock exchange. This offers investors a high level of liquidity because the units can be purchased or sold at market rates.

How does closed end funds work?

Closed-end funds pool investors' money to invest in a portfolio of securities, such as stocks or bonds. Closed-end funds, as opposed to open-end funds, have a set number of shares that are traded on stock exchanges. Investors purchase and sell these shares on the secondary market, and the fund's market price is controlled by supply and demand. The fund's manager actively manages the portfolio to meet investment goals, and investors may receive dividends from the fund's holdings.

Trends that can impact closed end funds for a business.

Some of the trends that can impact the closed end funds for a business:

• Interest rate fluctuations can majorly influence closed-end funds, particularly those that invest in fixed-income assets. Rising interest rates may lower bond prices, reducing the fund's net asset value (NAV).

In contrast, lowering interest rates may cause bond values to rise, increasing the NAV. Fund managers must alter their strategy to navigate changing interest rate conditions.

• Market volatility can significantly influence the performance of closed-end funds, particularly those investing in equities. Abrupt market downturns may lead to a decline in the fund's market price, even if the underlying portfolio remains fundamentally strong. However, it's important to note that periods of heightened volatility can present opportunities for active fund managers to leverage market fluctuations and potentially generate alpha for investors. This underscores the importance of fund managers remaining agile and responsive to market developments to maximise returns and mitigate risk.
• Abrupt market downturns may lead to a decline in the fund's market price, even if the underlying portfolio remains fundamentally strong. However, it's important to note that periods of heightened volatility can present opportunities for active fund managers to leverage market fluctuations and potentially generate alpha for investors. This underscores the importance of fund managers remaining agile and responsive to market developments to maximise returns and mitigate risk.

Example
 

Let us understand this by assuming the following:

BlackRock Enhanced Capital and Income Fund (BSE: CII), a prime example of a closed-end fund, stands out for its unique management by BlackRock. This fund is designed to offer investors a distinctive blend of income and capital growth, setting it apart from its peers.

The net asset value (NAV) currently stands at ₹750 per share. With a fixed number of outstanding shares, let's say 10 million, the fund's total net asset value would be ₹7.5 billion.

The strategic use of leverage, typically around 30% of its assets, is a key driver of its potential returns. Assuming a leverage amount of ₹2.25 billion, the total assets under management (AUM) would reach ₹9.75 billion, offering investors a potentially lucrative opportunity.

CII's investment strategy involves allocating approximately 60% of its portfolio to equities and 40% to fixed-income securities. With an AUM of ₹9.75 billion, this would mean approximately ₹5.85 billion allocated to equities and ₹3.9 billion to fixed-income securities.

One of the advantages of investing in CII is the ability to trade its shares on the BSE, similar to stocks. Let's assume the current market price of CII's shares is ₹770, trading at a premium to its NAV. With 10 million shares outstanding, CII's market capitalization would be ₹7.7 billion, reflecting its high liquidity and marketability.

CII regularly pays dividends to shareholders. Its annual dividend yield is 7%, based on the current market price of ₹770 per share. This would translate to a dividend payout of ₹53.90 per share annually.

CII offers investors an opportunity to gain exposure to a professionally managed portfolio of securities, trading like a stock on the BSE, with the potential for income and capital appreciation.

FAQ

What is the difference between open-ended and closed-ended mutual funds?

The primary differences between open-ended and closed-ended mutual funds are their structure and trading method. Open-ended mutual funds regularly issue and redeem shares in response to investor demand, allowing investors to buy or sell shares directly from the fund at its net asset value (NAV). 

On the other hand, closed-ended mutual funds have a fixed number of shares that are traded on stock exchanges and can be bought and sold by investors. Closed-ended funds have a fixed structure, which means they do not issue or redeem shares directly with the fund, and their market price is decided by secondary market supply and demand.

Why would an investor choose a closed-ended mutual fund over an open-ended one?

Investors may prefer closed-ended mutual funds for a variety of reasons. To begin with, closed-ended funds may provide access to specific markets or specialised investment methods that open-ended funds do not. Closed-ended funds may also trade at a discount or premium to their net asset value (NAV) in the secondary market, allowing investors to purchase assets for less than their intrinsic value. 

Also,  closed-ended funds may have lower ongoing management fees than open-ended funds because they do not issue and redeem shares regularly, lowering operational costs. Open-ended mutual funds can give investors unique choices and potential cost savings.