Closed-End Funds vs Open-End Funds (Investing in CEFs) - YouTube

Open end funds are a pretty standard type of  investment, which include things like mutual  

funds and index funds. Closed-end  funds are a less common investment,  

but they offer some pretty significant  advantages because they are typically able  

to offer higher returns and higher yields than  funds in the open-end category. In this video,  

we’re going to take a look at the key differences  between closed end and open end funds in order to  

determine which of these is a better investment  for investors like you and me. Let’s get started.

Open End Funds Explained So first, let’s start with the  

characteristics of an open end fund so we can  properly compare the qualities of each type of  

investment. Open-end funds are named because they  are always open to and accepting new investments.  

What this means is that mutual funds and  ETFs that are in the open-end category  

are able to continue issuing new shares as  new investors become interested in the fund.

For this reason, the number of shares that an  open end fund can issue is essentially unlimited.  

Take VOO for example, which is an open-end  ETF from Vanguard that tracks the S&P500  

index. The roughly 520 million outstanding  shares represents $160 billion of assets.  

But let’s say demand increases and there’s  $2 billion of additional demand for VOO.  

Instead of this demand driving up the price  of the fund, Vanguard simply issues additional  

shares and lumps those $2 billion in  with the rest of the fund’s assets.

So with open-ended funds, the pool of money  that is actually being invested into stocks  

is variable. This can be a good thing for  funds like VOO which are designed to track  

the performance of a certain index, because  it can minimize some of the volatility that  

comes from market pressure and demand.  It keeps the price more in line with NAV,  

or net-asset value, which is the market  value of all of the assets in the fund.

Now VOO is technically an open-end fund in the  way it's designed, but as an ETF, it doesn’t trade  

like a true open-end fund. This is because most  open-end funds don’t actually trade on exchanges.  

You typically purchase open-end fund  shares directly from an investment  

firm like Vanguard or Fidelity. And this brings  us to the primary downside of open-end funds.

Because open-end funds traditionally don’t trade  on exchanges, you have to buy them and sell them  

directly from the investment firm. This means  the investment firm must hold enough cash on hand  

to meet whatever demands that investors have.  Basically, if a bunch of investors decide they  

want to sell the shares of their open-end fund,  in a process that’s called “redeeming” shares,  

the investment firm has to have enough cash  to pay for all of those shares. In order to  

be prepared for that, a certain portion of the  fund’s assets will be kept in cash at all times.  

And this is the issue - because not all of the  assets of an open-end fund will be invested.  

I couldn’t find a clear answer on this, but  it seems like most funds keep from 5 to 10%  

of their assets as cash. So this means for every  dollar you’re investing into an open-end fund,  

only 90 to 95¢ is actually being invested.  This will effectively reduce the returns  

you see from your investments because  not every dollar is being put to use.

So let’s take a look at how this  differs from closed-end funds. 

Closed End Funds Explained As you might have guessed by now, a closed end  

fund is not open to new investments. A closed end  fund raises all of its capital for its investments  

through an IPO when it is created. Once this  happens, there are no additional shares issued.

This makes closed end funds very different  because you can’t just buy them directly from  

the investment firm that manages the fund. You can  only buy shares of closed end funds on exchanges.  

Similarly, the investment firm is not responsible  

for buying those shares from  you when you want to sell.  

When you want to cash in on your investments,  you’ll have to sell them on an exchange.

Since the closed end fund does not have  the responsibility to buy your shares,  

they don’t have to keep cash on hand like an  open end fund. For this reason, closed end  

funds often have 100% of their assets actively  invested, which means they can theoretically  

generate higher returns than an open-end fund  that is invested in an identical portfolio.

But these characteristics also have added  

benefits for investors who are  interested in closed end funds.

First of all, since shares of closed end  funds can only be purchased on an exchange,  

they are entirely vulnerable to the  effects of market supply and demand.  

This means that the market price of a  closed-end fund is rarely identical to the price  

of the underlying assets, or NAV. Shares often  trade at a premium or a discount to the NAV.  

I personally think this is really cool because  you can theoretically buy a share of a portfolio  

of investments for less than it would cost you  to replicate that portfolio. And the possibility  

of getting the underlying investments at a  discount is a big advantage of closed-end funds.

The second benefit comes back to the fact that  closed end funds don’t have to keep cash on hand.  

They never have to worry about an investor  coming back to them to redeem shares,  

so they can be much more creative  or unconventional with their  

investments. They don’t have to worry as much  about investing in liquid assets, because  

it’s highly unlikely they’ll need to liquidate  any holdings on short notice. And ultimately,  

this means they’ll be able to make investments  that open end funds wouldn’t have access to.  

And this is another component that helps them  generate higher returns than an open end fund,  

because they simply have more options.

Another interesting aspect to this is that  a closed end fund can’t raise more capital  

to acquire new investments. An open  end fund can continue to attract new  

investors and use their capital to expand  the portfolio, but a closed end fund has  

to entirely rely on their performance to  continue growing the portfolio. I think  

this is exciting because they have to be that  much more responsible with their strategy,  

but it can also easily be a bad thing if the  fund managers are irresponsible or unsuccessful.

So let me quickly summarize the differences  between closed end funds and open end funds  

and then we’ll get into some of the  specifics of what to look out for  

when making these kinds of investments.

Open end funds are always accepting new  capital. Closed end funds raise capital once,  

during an IPO, and do not gain any  additional capital in the future.

Open end funds are bought and redeemed directly  from investment firms. They have to keep cash  

available so that investors can redeem their  shares at any time. With the necessity of having  

cash on hand, open end funds cannot invest 100% of  their assets. This means slightly lower returns.

Closed end funds are bought and sold  exclusively on exchanges. They have no  

liquidity obligations to investors, and this  means they can invest 100% of their assets,  

and can invest them in more illiquid assets  that open end funds cannot invest in.

Open end funds are often priced at NAV,  

while closed end funds can trade at  a discount or premium to the NAV.

So as you can see, closed end funds can  offer higher returns and at discounted  

prices compared to what you can  expect from an open-end fund.  

But this doesn’t automatically make any closed end  fund a better investment than an open end fund.  

So before you dive in, let’s take a look at  some important qualities of closed end funds.

In my opinion, there are four main categories  that I want to look at before investing in  

a closed-end fund. And these four things are  the diversification of the underlying assets,  

any leverage or debt that the fund is using,  

costs or fees associated with the  investment, and the tax consequences  

associated with holding the investment,  particularly when it comes to dividends.

So with any fund or ETF investment, the first  thing I want to look for is diversification.  

It’s fairly common knowledge that diversifying  your investments is the safest way to protect your  

portfolio from any disasters. Now any closed-end  fund will obviously be more diversified than an  

individual stock, but there are many closed-end  funds that focus their strategies on a particular  

market sector, like Real Estate, while others  focus on a specific type of underlying investment,  

like MLPs or municipal bonds. None of these  are necessarily a red flag to begin with,  

but if you’re going to invest in a closed-end  fund, you have to make sure you understand what  

exactly they’re investing in. Otherwise, you might  find your portfolio overweight in a certain asset  

class or industry. Similarly, it’s important to  understand what a closed end fund invests in so  

that you understand where their profits come from.  If they’re offering a 10% yield, you’ll want to  

make sure their investments support that yield or  else they might just be selling their assets - and  

therefore decreasing their capital and the  fund’s NAV - to fund distributions to investors.

The next thing you want to look for is a fund’s  use of leverage. Since these funds can’t raise  

any more capital from investors, one of the only  ways they can get more cash is to borrow it.  

Closed-end funds are legally capped at a  ratio of 33% leverage when it comes to debt.  

This means for every dollar in the  fund, they can borrow no more than 33¢.  

Leverage isn’t necessarily a bad thing, because  it can be a great way for a fund to generate even  

more profits for investors without having to have  more capital. But, leverage does make a portfolio  

more volatile. So you might see these funds  react significantly to drops in the market.  

Also, the interest from any borrowed money will  be passed onto you through expenses and fees.  

So you have to be careful when you  see funds that are highly leveraged.

And that brings us to the costs and fees  associated with closed end funds. Like I said, you  

can expect any leverage in the portfolio to result  in an added fee for you as an investor. This is  

listed as “interest expense”. Additionally, you’ll  pay management fees, which can be pretty high  

considering that all of these funds are actively  managed. Management fees of any percentage can  

add up over time, so you really want these fees  to be as low as possible. And this is a rule I  

stick to with most investments, but I’m actually a  little more lenient on fees from closed end funds,  

and here’s why. Fees come out of the funds NAV, or  net asset value. But closed end funds are unique  

because they often trade at a discount to that net  asset value. So from my perspective, if a fund has  

fees of 2%, but it’s trading at a 10% discount,  I’m still getting the underlying assets in my  

portfolio at an 8% discount. Of course, that  also assumes the fund is only temporarily at a  

discount, and there are certainly some funds  out there that are perpetually discounted,  

so that’s just something to think about as  you’re looking into specific closed end funds.

And finally, you have to consider  the tax consequences of these funds.  

Many closed end funds are designed around income  producing strategies. This is great because you  

can get really high dividend payments, you just  have to take a closer look and make sure the  

dividends you receive are going to be taxed to  your benefit. Like I touched on earlier, there  

are many funds that focus on municipal bonds,  which provide tax-free income. Although, these  

investments are really only beneficial to people  in really high tax brackets, and I actually made a  

whole video about municipal bond investing if you  want to learn more about that. But for the rest  

of the closed end funds out there, they’re going  to produce taxable income. So the dividends that  

you receive from these funds will either be taxed  at your income tax rate, or at the capital gains  

tax rate. Obviously, you want to make sure they’re  taxed at the capital gains tax rate because that  

is what is going to cost you the least in terms  of taxes. But, there’s one other element here  

in the event that a fund isn’t generating  enough profit to pay you those dividends.

Some funds are categorized as “managed  distribution” funds, which means they have a  

target distribution rate that they try to deliver  on every month or every quarter. The problem is,  

if the fund doesn’t generate enough money, they  still want to be able to provide that target  

distribution rate. In these cases, the fund will  actually sell some of its holdings and give them  

to you as a “return of capital”. These aren’t  taxed immediately, which sounds good at first,  

but there are two problems with this. First, a  return of capital reduces the cost basis of your  

shares. This means that when you sell your shares  in the future, your profits on that investment  

will be calculated using the price you paid for  the share initially minus all of the “return of  

capital” you received. When this happens, you  will end up being responsible for paying capital  

gains taxes on all of the distributions that you  previously received that were an untaxed return of  

capital. Simply put, you might be responsible for  a larger tax bill than you anticipated when you  

sell your shares, so it’s important to be aware  that this might be happening. The second problem,  

which is just as concerning, is that when  the fund can’t afford your distributions,  

they’re selling their assets to be able to pay  you. This is not sustainable, because if this  

continues to happen, the fund will eventually  run out of assets and money. So while the tax  

situation can be manageable, you really want to  make sure the fund isn’t relying on this “return  

of capital” to pay you, because it can be a red  flag when it comes to the longevity of the fund.

I hope all of this gave you a better  understanding of the world of closed end funds.  

I’ve been learning from John Bogle and telling  myself for months that actively managed funds  

are dangerous - but I think closed end funds  are one of the few actively managed fund types  

that I might actually be interested in investing  in. The fact that they trade at a discount so  

frequently and are able to produce much larger  distributions than other investments makes them  

very attractive to me as a dividend investor.  Let me know what your thoughts are on closed end  

funds after watching this video, because I’d  love to discuss it with you in the comments.

And I know we didn’t take a look at  any specific closed end funds today,  

but don’t worry. Next week I’m going to use  everything we talked about today to find the  

best options when it comes to closed end funds,  with the primary goal of finding affordable,  

reasonably priced funds that offer capital  growth and competitive dividend distributions.  

So if you are interested in seeing that, make sure  you subscribe to the channel so you don’t miss it.  

Best of luck with your investments  and I will see you in the next video!