Closed-end funds (CEFs) offer unique features for investors seeking income, capital appreciation, and diversification.
One of their core strengths is the historic stability of their asset base. This stability translates into several advantages for investors, making CEFs a compelling choice within an overall asset allocation strategy.
Understanding the structure
Unlike open-end mutual funds, which continuously issue and redeem shares to meet investor demand, CEFs raise a fixed amount of capital through an initial public offering. This creates a closed pool of assets the fund manager can invest in and manage over the long term. This structure offers several benefits:
- Reduced reinvestment risk Open-end mutual funds face the challenge of reinvesting incoming cash from new investors.
This can disrupt the fund's investment strategy, forcing sales of existing holdings to accommodate new capital. CEFs, on the other hand, avoid this issue. With a fixed pool of capital, the manager can focus on long-term investment decisions without worrying about short-term cash flows. Furthermore, a closed-end fund manager does not need to hold excess cash to meet redemptions, meaning more of the portfolio can be invested.
- Flexibility for illiquid assets
CEFs' historically stable capital base allows them to invest in less liquid assets such as emerging market debt or private equity.
Open-end funds with frequent redemptions may struggle to hold these assets, as selling them quickly to meet investor demands might be difficult. CEFs, with their predetermined capital, can take advantage of these potentially higher-return opportunities without liquidity concerns.
Maximizing potential stability …
The closed-end structure allows for another layer of potential stability – leverage. CEFs can utilize moderate leverage by issuing debt instruments like preferred shares. This adds to the fund's total assets, potentially amplifying returns. However, strict regulations limit the amounts of leverage that funds may use, ensuring a healthy balance between debt and equity.
The stable capital base allows CEF managers to employ active management strategies.
Furthermore, the stable capital base allows CEF managers to employ active management strategies. Unlike index-tracking ETFs, CEFs have the flexibility to make selective investment choices based on managers’ expertise and analyses. This active management can potentially outperform the broader market over time, offering investors a chance for superior returns.
… And beyond
The stability of the asset base is just one facet of the CEF advantage. Here are some additional factors that contribute to their appeal:
- High yield potential
Many CEFs are designed to generate consistent income, often through investments in higher-yielding assets. This focus on income generation can be attractive for investors seeking a steady cash flow stream.
- Discount to NAV
Unlike ETFs, which generally trade close to their Net Asset Value (NAV), CEFs often trade at a discount to their NAV. This discount allows investors to purchase assets at a price lower than their actual value.
Final thoughts
The stable asset base of CEFs provides a strong foundation for various investment strategies. It allows managers to focus on long-term goals, potentially access less liquid but potentially higher return assets, and utilize leverage responsibly. Combined with the potential for high yields, discounts to NAV, and active management, we believe CEFs can be a valuable portfolio addition for investors seeking income, growth, and diversification.
Important information
Closed-end funds are traded on the secondary market through one of the stock exchanges. The Fund's investment return and principal value will fluctuate so that an investor's shares may be worth more or less than the original cost. Shares of closed-end funds may trade above (a premium) or below (a discount) the net asset value (NAV) of the fund's portfolio. There is no assurance that the Fund will achieve its investment objective.
Past performance does not guarantee future results.
The use of leverage will also increase market exposure and magnify risk.
Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments. Unlike mutual funds, which continuously sell newly issued shares and redeem outstanding shares, most closed-end funds offer a fixed number of shares in an initial public offering (IPO) that are then traded on an exchange. Open-end funds can be bought or sold at the end of each trading day at their net asset values (NAVs). Because closed-end funds trade throughout the day on an exchange, the supply and demand for the shares determine their market price; closed-end funds'; market prices may fluctuate through the trading day and those prices may be higher or lower than their NAVs. Closed-end funds and mutual funds charge investors annual fees and expenses. All of these products may use leverage to enhance their returns, which can magnify a fund's gains as well as its losses. Closed-end funds typically do not have sales-based share classes with different commission rates and annual fees. Both vehicles seek to deliver returns based on their investment objectives, but neither is FDIC insured. The Revenue Act of 1936 established guidelines for the taxation of funds, while the Investment Company Act of 1940 governs their structure. Aberdeen Standard Investments does not provide tax or legal advice; please consult your tax and/or legal advisor.
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