Closed-End Funds

Tap Illiquid Markets with Closed-End Funds

While many investors are very familiar with open-end funds, such as mutual funds and exchange traded funds (ETFs), certain closed-end fund (CEF) structures have been rapidly gaining popularity for various reasons — mainly because they offer alternative investment options.

Over the past few years, asset managers such as BlackRock, KKR, Carlyle and PIMCO — as well as Aspiriant — have started interval funds or tender offer funds, types of CEFs that provide access to less liquid investment strategies to investors in an attempt to increase returns, with a little more risk.

Before you invest in any CEF, it’s important to understand how each type works and to talk to your financial advisor to make sure it’s appropriate for your portfolio. Here, we give a basic breakdown of publicly traded CEFs, interval funds and tender offer funds.

What is a closed-end fund?

Legally known as a closed-end investment company, CEFs are like mutual funds in that they are registered with the Securities and Exchange Commission (SEC) and individual investors pool their money to be professionally managed by Registered Investment Advisers. However, as implied in the name, CEFs issue a limited number of shares. CEFs generally are taxed as regulated investment companies and issue a Form 1099. But they may issue a K-1 if they hold a number of partnership investments or invest primarily in hedge funds or private equity funds.

Why a closed-end fund?

The closed-end structure allows the funds to invest in a broader opportunity set, including alternative strategies and asset classes that are not always suitable for open-end mutual funds. These additional investment options include, but are not limited to, real estate (beyond real estate investment trusts), private placement debt, private equity, hedge funds and venture capital funds. The structure also allows portfolio managers to potentially employ leverage to increase exposure to investments while enhancing income and capital appreciation potential.

Meanwhile, a newly adopted liquidity risk management program rule by the SEC limits open-end funds to investing only up to 15% of their net asset value in the illiquid investments. Since the 15% restriction does not apply to CEFs, portfolio managers have greater access to illiquid markets and can invest more assets in less liquid or illiquid investments that provide for a different return pattern than traditional bond and equity investments.

But similar to a mutual fund or ETF, CEFs have regulatory oversight from a board of independent trustees and regular public filings with the SEC, providing a higher level of oversight and disclosure than traditional private funds that invest in illiquid investments.

What are the types of CEFs?

Publicly traded closed-end funds
Traditional closed-end funds raise capital through an initial public offering (IPO) and issue a fixed amount of non-redeemable shares. The portfolio managers invest the capital in accordance to the fund’s strategies and objectives as outlined in its prospectus. After the IPO, the shares trade on secondary markets, such as a stock exchange, like stocks and ETF shares. The price of the shares is set by the market and usually does not match the fund’s net asset value (assets less liabilities). Therefore, the fund typically trades at a market premium (above NAV) or at a market discount (below NAV) depending on demand for the shares in the CEF.

Interval funds
Interval funds differ from traditional CEFs because they offer shares on a continuous basis at net asset value. And they are not listed on a stock exchange. Interval funds provide liquidity to the shareholders by periodically buying back a portion of the outstanding shares (monthly, quarterly, bi-annually or annually) at net asset value. They typically offer liquidity between 5% and 25% of the fund’s total common shares outstanding over the course of the year. Limited redemptions allow interval funds to invest in a wide variety of investments, particularly less-liquid investments that could earn shareholders greater yields and higher potential returns in exchange for the liquidity risk.

Depending on the asset classes the interval funds invest in, they may be available to only accredited investors. Generally, accredited investors have either annual income of $200,000 for individuals/$300,000 for married couples, or net worth over $1 million, excluding your primary residence. Last year, the SEC broadened the definition of accredited investors.

Tender offer funds

Tender offer CEFs are so similar to interval funds, they tend to be called interval funds even if that is not what they are by SEC definition. Like interval funds, they can offer shares on a continuous basis at the NAV. These funds are not traded on the secondary market, and shareholders can redeem shares during repurchase offer periods. In most cases, only accredited investors can buy tender offer shares.

Tender offer funds, however, have more discretion on buy-back policies, including the frequency and amount, but they are generally done quarterly. Tender offer funds are also often valued on a delayed basis, therefore the proceeds paid are delayed as well.

What are the risks?

Just like any other investment product, CEFs are exposed to various risks. Most risks that apply to mutual funds apply to CEFs, depending on the asset classes the fund invests in. However, CEF’s limited redemptions, potentially higher leverage and less-liquid investments increase related risks while also enhancing the return potential.

Today, the stock market seems to be overheated, particularly for U.S. companies, while fixed income yields remain historically low. So it’s no surprise that fund managers as well as investors are attracted to CEFs because they may provide additional diversification and higher returns to a balanced portfolio. Be sure to talk with your investment advisor or wealth manager to weigh whether CEFs, particularly interval and tender offer funds, can help you reach your financial goals.

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