By Grant Thayer
A closed end fund represents a portfolio of investments that is run by a professional fund manager. Different from an open end (mutual) fund, which issues and redeems its shares directly, closed end funds have a set number of shares that trade like shares of stock. The purpose of the closed end fund is to provide an investment vehicle for a portfolio needing liquidity while allowing the fund manager a platform for a long term investment strategy without having to sell and issue new shares daily. Meaning, an illiquid position need not be sold to cover redemptions by clients. However, the closed end fund is tragically flawed due to a lack of transparency.
Since the number of shares are predetermined and trade on the market, the price of the shares is set by supply and demand and can therefore trade at either a premium or discount to the underlying investments’ net asset value (NAV). The premium or discount to NAV is available to investors on sources such as www.cefconnect.com. Since the NAV is not calculated daily as in an open end fund, the premium and discount data are not real-time, but rather based upon the NAV as last calculated for reporting purposes. While this is a little concerning, we believe that the prices of closed end funds tend to be “close enough” due to the lower turnover of most CEF’s. This is not why we are too concerned with NAV calculations except in high turnover CEF’s during volatile markets.
The real problem we see in closed end funds is in the concept and method of execution of the “managed distribution policy”. Since closed end funds are not continuously issuing and redeeming shares and can be easily designed as a long term, dividend-seeking strategy, the distributions to shareholders tend to be more predictable. Seeking to capitalize on this, many closed end funds have adopted the aforementioned “managed distribution policy” through which they deliver a perfectly consistent percentage distribution to investors. This consistent distribution percentage is widely misunderstood.
Unfortunately, the return on the underlying investments is obviously NOT perfectly consistent. If the return on the underlying investments falls short of the promised distribution, the difference is made up through a “return of capital,” meaning the fund sells some of its assets and returns a portion of the principal invested to the shareholders. In other words, to support the marketing gimmick of the consistent distribution percentage the closed end fund will give you some of the money back you originally invested to make up for any shortfall.
On the surface this seems to be such an absurd business practice that it could never persist, unless of course there was a near total lack of transparency, and it so happens that the managed distribution policy has persisted for decades. Investors do not learn of the amount of their return of capital portion of the distributions until year end tax reporting, if they bother to pay attention or even know to look, as investors obviously do not need to pay taxes on a mere return of capital.
While we find the practice of returning capital to investors in order to maintain a consistent percentage of distribution for marketing purposes to be laughable, we find the lack of transparency surrounding this practice to be deeply concerning. Due to this transgression we make every attempt to avoid the use of closed end funds in our portfolios, however, as I mentioned in the opening paragraph closed end funds can serve a purpose. If there is a position we wish to take and the closed end fund happens to be the only or the most effective vehicle with which to take that position, we will cautiously perform due diligence and consider purchasing shares. In my opinion investors would be well advised to take a similar approach. Caveat emptor.

Tags: CEF, Closed end funds, Grant Thayer, lee munson, mutual funds, NAV, net asset value, www.cefconnect.com.