Closed-End Funds for MASSMutual Employees

What Is a Closed-End Fund?

Numerous MASSMutual clients of ours have inquiries about closed-end funds. A closed-end fund is an investment corporation that pools funds from numerous investors and invests them in stocks, bonds, and other securities. During an initial public offering (IPO), a fund typically issues a fixed number of shares and purchases securities with the proceeds. The fund's capital structure and number of shares are determined at this time; the number of shares is fixed (hence the term 'closed-end'). Each investor possesses a portion of these holdings, which are represented by shares.

Closed-end funds may be an attractive option for retirees and pre-retirees looking to generate consistent income streams. According to a report by the Investment Company Institute (ICI) published in 2021, closed-end funds often provide higher yields than traditional mutual funds due to their unique structure, which allows them to invest in a wider range of assets, such as real estate and commodities. Additionally, closed-end funds may provide diversification benefits and the potential for capital appreciation. Retirees and pre-retirees should carefully consider their investment goals and risk tolerance before investing in closed-end funds.

A fund's net asset value (NAV) is the total value of its holdings divided by the number of outstanding shares. After its initial public offering, the fund trades on an exchange or the over-the-counter market like any other security. A professionally managed closed-end fund may be diversified or non-diversified. If the fund performs well, investors can benefit from share price appreciation, dividend income, and capital gains distributions if the fund sells individual securities at a profit during the year.

Closed-end funds, which were established in the nineteenth century, are frequently compared to mutual funds, which are more well-known despite being younger. A closed-end company is technically defined by the Investment Company Act of 1940 as 'any management company other than an open-end company' (such as a mutual fund). Although they are both categories of investment companies regulated by the Securities and Exchange Commission, there are substantial differences between the two. MASSMutual employees may want to understand both the differences and the similarities between these two categories of funds.

Even though closed-end funds have been around much longer than open-end mutual funds, there are far fewer of them; closed-end funds number in the hundreds, whereas open-end mutual funds number in the thousands. Although a closed-end fund and an exchange-traded fund (ETF) are distinct, there are some similarities that our MASSMutual may benefit from understanding. A closed-end fund has the same investment options as an open-end fund. Historically, however, the majority of closed-end funds were bond funds, with tax-exempt bond funds constituting the largest category.

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How Is a Closed-End Fund Different From an Open-End Fund?

As with many other investment companies, a closed-end fund offers diversification by investing in a variety of securities. However, we would like to remind our MASSMutual clients that diversification alone cannot guarantee a profit or protect against loss. In addition to providing diversification, a closed-end fund offers professional management and a consistent investment objective. Similar to mutual funds, closed-end funds do not pay taxes at the fund level but instead pass these tax obligations on to their shareholders.

One of the most important distinctions between a closed-end and an open-end fund that we want our MASSMutual clients to understand is that while an open-end fund must always be able to redeem your shares directly, most closed-end fund shares are traded on market exchanges and are generally not redeemed directly by the company that issues them. At the time of the IPO, the quantity of shares in a closed-end fund is predetermined. In contrast, an open-end fund issues and redeems shares daily--hence the term 'open-end'--and the number of shares fluctuates from day to day, affecting the fund's net asset value (NAV).

Similar to equities, closed-end funds trade throughout the day, and their prices also fluctuate throughout the day. This is distinct from an open-end fund, whose NAV is calculated only once per day after the markets close. If you wish to sell your shares of a closed-end fund, the propensity of other investors to purchase them will dictate the ease with which you can do so and the price you will receive.

Due to the fact that closed-end funds trade on market exchanges, the market price of a share can fluctuate based on market supply and demand. When demand exceeds supply, the market price of a closed-end fund's shares may trade at a premium to the fund's NAV, which represents the share's intrinsic value. When demand exceeds supply, closed-end fund shares may trade at a discount to their NAV. Although some closed-end fund shares trade at a premium, the majority trade at a discount. This is not the case for open-end funds, which will redeem your shares at the NAV as of the market close on the day you sell (or the next closing day if you sell after 4 p.m.).

Joan purchases 1,000 shares of a closed-end mutual fund. Each share is $14.50 for her. The NAV of the fund is $15.75. Essentially, Joan has acquired assets worth $15,750 for $14,500. Later, Joan sells her stock for $16. Her profit is $1,500 ($16,000 - $14,500), excluding transaction fees and commissions. If Joan had instead purchased her shares at $16 and sold them at $14.50, she would have sold her portion of the fund's assets for less than they were worth.

How Is a Closed-End Fund Different from an Exchange-Traded Fund?

Many MASSMutual clients inquire about the distinction between closed-end funds and exchange-traded funds. The concept of exchange-traded funds is much more recent than that of closed-end funds. In certain instances, an exchange-traded fund may be structured technically as a closed-end fund. Both are actively traded on main exchanges throughout the day. However, the majority of ETFs available today are passively managed; the fund's objective is to replicate the return of a given index as closely as feasible. Consequently, their market prices tend to follow closely the value of the securities in its portfolio, which in turn track the index. In contrast, closed-end funds typically trade at a premium or discount to their NAV.

Interval Funds

Technically, an interval fund is a closed-end fund that periodically gives its shareholders the option to sell back some or all of their shares. Shareholders must notify the fund by a specified date if they wish to accept the offer, which is typically made every three to six months or annually. The actual repurchase will occur at a price determined by the fund's NAV as of a specified date, typically shortly after the deadline for notifying the fund of a repurchase decision.

Contrary to the majority of closed-end funds, however, an interval fund possesses characteristics of both closed-end and open-end funds. As with mutual funds, an interval fund may choose to continuously offer shares at a price based on the fund's NAV. And unlike the vast majority of closed-end funds, shares of an interval fund may be priced daily. However, because shares are not redeemed on a daily basis, the SEC classifies them as closed-end funds.

Strengths of a Closed-End Fund

• Shares of closed-end funds that are acquired at a discount provide a form of leverage - the potential to profit not only from increases in the value of the fund's holdings, but also from increases in demand for the shares themselves. This leverage has the potential to increase your investment's returns.

 Some closed-end funds borrow money at a comparatively low cost and invest it in higher-yielding securities. This can increase a fund's return as long as interest rates are declining or remain low. However, when interest rates rise or the availability of low-cost credit disappears, leveraged bond funds may underperform other bond funds that do not use leverage.

 Due to the fixed number of shares, a closed-end fund is not required to set aside cash to manage redemptions. This capital can be used to attempt to increase investor returns. In addition, because shareholders do not redeem shares directly, a manager is not required to sell assets to cover unexpected shareholder redemptions, allowing them to invest in less liquid securities.

Contrary to an open-end fund, the investment strategy of a closed-end fund is not required to accommodate abrupt inflows of capital from shareholders. Such unanticipated inflows may require a fund to purchase securities in order to invest the money, even if the manager believes the market is already costly; a closed-end fund manager does not face this issue.

The board of directors of a closed-end fund may occasionally resolve to convert the fund to an open-end structure. If this were to occur, investors who purchased shares at a discount to the NAV could profit from the difference between their discounted purchase price and the NAV of the newly created open-end fund.

 Due to the fact that closed-end funds are traded and priced throughout the day rather than at the end of the business day, you have greater control over the price you receive when selling and the timing of your sales.

 On the secondary market, there are no minimum purchase requirements for closed-end funds.

Due to the fact that closed-end funds are transacted on the secondary market; they typically do not incur the same marketing costs as open-end funds.

Tradeoffs with a Closed-End Fund

• The market price of a closed-end fund may decline if investor demand decreases. If the market has a negative perception of the fund or fund manager, or if there are other market conditions extraneous to the fund itself, demand can decrease. In addition, the share price may decline even if the fund manager has made wise investments and increased the fund's asset value.
• Closed-end funds have greater flexibility to invest in illiquid securities than mutual funds, which can be problematic if the fund manager needs to sell these securities. In general, an illiquid security is one that cannot be sold within seven days at the approximate price used by the fund to calculate NAV.
• Due to the fact that leverage magnifies losses as well as increases return, a closed-end fund that employs leverage may underperform an unleveraged fund if its strategy does not perform as well as anticipated, such as if interest rates rise or the supply of cheap credit contracts, as can occur during a credit crisis.
• Purchasing shares at a premium may increase losses; if investor demand decreases, the value of your shares will decrease as well. Even if the fund manager performs well and increases the value of the fund's assets, a lack of investor demand can cause the fund's market price to decline below your purchase price as well as the fund's NAV. Due to the fact that they may trade at a premium or discount, closed-end funds may be subject to greater volatility than their open-end counterparts.
• If the board of directors decides to issue new shares through a rights offering, which could dilute the value of existing shares, the fund's capital can be increased.
• A closed-end fund is subject to the same market risks as any fund that invests in stocks or bonds, such as the risk that a bond will default, prepay, or be called early; that a company will declare bankruptcy; and that inflation, interest rates, credit availability, political or economic conditions, and/or currency risk will impact the value of the fund's holdings.
• The performance of closed-end funds may not be as easily accessible as that of open-end funds. They may also be less liquid.

Conclusion

Investing in closed-end funds is like buying a ticket to a limited-time show. Just as a theater production has a fixed number of seats, a closed-end fund has a set number of shares available. Once those shares are sold, the show (or fund) is closed to new investors. And just like a popular play can generate high demand for tickets, a successful closed-end fund can attract a lot of investor interest, potentially leading to higher returns. However, just as some shows are better than others, it's important to research and choose a closed-end fund that aligns with your investment goals and risk tolerance.