Closed-End Funds for Cheniere Energy Employees

What Is a Closed-End Fund?

A closed-end fund is an investment company that pools money from many people and invests it in stocks, bonds, or other securities. A fund typically issues a fixed number of shares during an initial public offering (IPO) and buys securities with the proceeds. The fund's capital structure and the number of shares in the fund is determined at this time; that number of shares available does not change (hence the name 'closed-end'). Each investor owns shares, which represent a part of these holdings.

A fund's net asset value (NAV) represents the total value of those holdings divided by the number of shares outstanding. After the initial IPO, the fund trades on an exchange or in the over-the-counter market, just as any other security would. A closed-end fund is professionally managed and can be either diversified or nondiversified. If the fund does well, an investor can enjoy share price appreciation, dividend income, and, if the fund sells shares of individual securities for a profit during the year, capital gains distributions.

Closed-end funds, which were first created in the 19th century, are often compared to mutual funds, which are more widely known even though they are newer. Technically, the Investment Company Act of 1940 defines a closed-end company as 'any management company other than an open-end company' (such as a mutual fund). Though there are some similarities and both are types of investment companies regulated by the Securities and Exchange Commission, they actually have some substantial differences.

For one thing, even though they have been in existence for a much longer time than mutual funds, there are far fewer closed-end funds available; closed-end funds number in the hundreds, compared to the thousands of open-end mutual funds. A closed-end fund also is different from an exchange-traded fund (ETF), though again, there are some similarities that we'd like to point out to our clients from Cheniere Energy. A closed-end fund can invest in the same types of investments as an open-end fund. However, historically, the majority of closed-end funds have been bond funds, with tax-exempt bond funds being the largest category.

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

Like many other investment companies, a closed-end fund offers diversification by investing in many different securities (though diversification alone can't guarantee a profit or protect against the possibility of loss). It also offers professional management and a clearly defined, consistent investment objective. Like mutual funds, a closed-end fund does not pay tax at the fund level but passes those tax liabilities on to shareholders.

One of the biggest differences between a closed-end and an open-end fund we'd like our Cheniere Energy clients to understand is that shares of most closed-end funds are traded on market exchanges, and generally are not redeemed directly by the company that issues them. By contrast, an open-end fund must always be ready to redeem your shares directly. The number of shares in a closed-end fund is fixed at the time of the IPO. By contrast, an open-end fund issues and redeems shares daily--that's why they're referred to as 'open-end'--and the number of shares varies from day to day, which affects its net asset value (NAV).

A closed-end fund trades throughout the day, just as stocks do, and its price also varies throughout the day. That's different from an open-end fund, which is priced only once a day when its NAV is calculated after the markets close. If you want to sell your shares of a closed-end fund, the willingness of other investors to buy them will determine how easy it is to sell them and the price you will receive for your shares.

Because closed-end funds trade on market exchanges, the market price of a share can fluctuate with the supply and demand of the market. When demand exceeds supply, the market price at which the shares of a closed-end fund trade may be at a premium to its NAV, which represents the intrinsic worth of a share of the fund's assets. Conversely, when supply exceeds demand, a closed-end fund's shares may trade at a discount to its NAV. Though some funds trade at a premium, most closed-end fund shares trade at a discount. This is not true of an open-end fund, which will redeem your shares at the NAV as of the market close on the day you sell (if that occurs after 4 p.m., you'll receive the NAV as of the next closing day).

Example(s):  Joan purchases 1,000 shares of a closed-end fund. Each share costs her $14.50. The fund's NAV is $15.75. Essentially, Joan has bought $15,750 worth of assets for $14,500. Joan later sells her shares for $16. Her profit (not including transaction costs or commissions) is $1,500 ($16,000 minus $14,500). However, had Joan bought her shares at $16 and later sold them when they were trading for $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 clients we speak to from Cheniere Energy ask about the difference between a closed-end fund and an exchange-traded fund. Exchange-traded funds are a much more recent investment concept than closed-end funds. In some cases, an exchange-traded fund may technically be structured as a closed-end fund. Both trade throughout the day on major exchanges. However, in general, most ETFs available today are passively managed; the fund's objective is to try to replicate as closely as possible the return of a given index. As a result, their market prices typically tend to closely track the value of the securities in its portfolio, which in turn track the index. By contrast, the typical closed-end fund usually trades at a premium or a discount to its NAV.

Interval Funds

An interval fund is technically a closed-end fund that periodically offers its shareholders the option to sell some or all of their shares back to the fund. Shareholders who want to accept the offer, which is generally made every three to six months or annually, must notify the fund by a specified date. The actual repurchase will occur later, at a price based on the fund's NAV as of a specified date, typically sometime shortly after the deadline for notifying the fund about a repurchase decision.

However, unlike most closed-end funds, an interval fund has some characteristics of both closed-end and open-end funds. An interval fund may choose to continuously offer shares at a price based on the fund's NAV, as a mutual fund does. And unlike most closed-end funds, an interval fund typically does not trade on the secondary market, but may price shares daily. However, because shares are not redeemed daily, they are classified as closed-end funds by the SEC.

Strengths of a Closed-End Fund

•  Shares of closed-end funds that are purchased at a discount offer a form of leverage--a potential opportunity to profit not just from any increases in the value of the fund's holdings, but from any increases in demand for the shares themselves. This leverage can potentially improve the returns of your investment.
•  Some closed-end funds literally use leverage; they borrow funds at a relatively low cost and invest it in higher-yielding instruments. As long as interest rates are falling or remain low, this can increase a fund's return. However, when interest rates rise or the availability of low-cost credit disappears, such funds can suffer and may lag other bond funds that don't use leverage.
•  Because the number of shares is fixed, a closed-end fund does not need to set aside cash to handle shareholder redemptions. That cash can be employed to try to enhance investor returns. And because shareholders do not redeem shares directly, a manager also is not forced to sell assets to meet unexpected shareholder redemptions, which can enable the manager to invest in less liquid securities.
•  Unlike an open-end fund, a closed-end fund's investment strategy does not have to accommodate sudden inflows of new money from shareholders. Such unanticipated inflows can mean a fund must buy securities to put the money to work even if the manager feels the market is already expensive; a closed-end fund manager does not have that problem.
•  Occasionally, a closed-end fund's board of directors may decide to convert the fund to an open-end structure. If that were to happen, shareholders who bought at a discount to the NAV might profit from the difference between their discounted price and the NAV of the newly minted open-end fund.
•  Because closed-end funds are traded and priced throughout the day rather than at the close of business, you have greater control over what price you'll receive when you sell, and when shares are sold.
•  There are no minimum purchase requirements for a closed-end fund bought on the secondary market.
•  Because closed-end funds are traded on the secondary market, they generally do not have the same kind of marketing expenses that an open-end fund does.

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Tradeoffs with a Closed-End Fund

•  A closed-end fund's market price may decrease if investor demand diminishes. Demand can diminish if the market has a poor perception of the fund or fund manager, or because of other market conditions unrelated to the fund itself. Also, the share price can drop even if the fund manager has invested well and increased its asset value.
•  Closed-end funds have more flexibility to invest in less liquid securities than mutual funds, which can be a problem if the fund's manager needs to sell those securities. An illiquid security generally is considered to be a security that can't be sold within seven days at the approximate price used by the fund in determining NAV.
•  Because leverage magnifies losses as well as enhances return, a closed-end fund that uses leverage may perform worse than an unleveraged fund if its strategy doesn't perform as well as expected--for example, if interest rates rise or the supply of cheap credit contracts, as can occur during a credit crisis.
•  Buying shares at a premium can potentially increase losses; if investor demand drops, the value of your shares will drop also. Even if the fund's 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 fall below not only your purchase price but below the fund's NAV. Because they may trade at a premium or discount, closed-end funds may experience greater volatility than an equivalent open-end fund.
•  A fund's capital can be increased if its board of directors decides to issue new shares through a rights offering, which could dilute the value of existing shares.
•  A closed-end fund is subject to the same market risks as any fund that invests in stocks or bonds--for example, the risk that a bond will experience default, prepayment, or be called early; that a company will go bankrupt; that inflation, interest rates, credit availability, political or economic conditions, and/or currency risk will affect the value of the fund's holdings.
•  Information about closed-end fund performance may not be as readily available as with open-end funds. Also, they may be less liquid.

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