Closed-end funds can be appealing investment products because some offer distribution rates as high as 7 percent or more. But a fund's distribution rate isn’t guaranteed, and closed-end funds come with their own set of risks. Before you invest in a closed-end fund, be sure you understand how they operate, as well as what a distribution rate is and where the fund gets the money to pay distributions.
Closed-End Fund Basics
A closed-end fund is a type of investment company that pools money from investors to buy securities. Closed-end funds are similar to mutual funds in that they professionally manage portfolios of stocks, bonds or other investments (including illiquid securities). 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.
When you buy shares in a closed-end fund IPO, you'll pay a premium because the fees and expenses paid for the offering come from the capital raised. In other words, if you pay $10 for a share, the actual amount invested for you will be less than $10. After a closed-end fund goes public, you can buy shares in the secondary market on an exchange, paying the fees that your brokerage firm charges for this type of transaction.
Because closed-end funds trade like stocks, the supply and demand for the shares determines their market price. Both closed-end funds and mutual funds have an inherent net asset value (NAV) that reflects the value of the funds' underlying assets (less liabilities) divided by the number of shares outstanding. Closed-end funds also have a market price that fluctuates throughout the trading day; that price may be higher or lower than its NAV. You can get information on a closed-end fund's current price and NAV on the fund's website or that of the exchange where it trades. Information on a fund's portfolio holdings is usually available on the fund's website and in company filings submitted to the Securities and Exchange Commission (SEC).
Most closed-end funds have historically traded at a discount to NAV—a market price lower than the fund's NAV. However, some may trade at a premium to NAV—a market price higher than the fund's NAV. In contrast, shares of a mutual fund are always priced based on the NAV, which is set daily at the close of trading.
Both closed-end funds and mutual funds charge investors annual fees and expenses and might use leverage to enhance their returns, which can magnify a fund's gains as well as its losses. Both fund types can invest in illiquid securities, but closed-end funds generally aren’t impacted by redemptions and are allowed to hold a greater percentage of illiquid securities in their investment portfolios.
Distribution Rates: Where the Money Comes From
Some closed-end funds pay distributions to investors on a monthly or quarterly basis. They may change the distribution rate from one distribution period to the next. Depending on a closed-end fund's underlying holdings, its distributions can include interest income, dividends, capital gains or a combination of these types of payments. In some cases, distributions also include a return of principal, sometimes referred to as a return of capital. That means the monies used to pay the distribution come from the fund's assets rather than from any income generated by the investments in the fund's portfolio.
Closed-end funds that return capital can carry a higher level of risk because the fund is eroding the asset base available to generate income to pay distributions. Some closed-end funds set a specific distribution rate to pay regardless of the income generated by the fund. In that case, it’s more likely that a fund might return capital to investors along the way. Before you invest in a fund, find out if it follows this approach, also known as a managed distribution policy.
Don’t confuse a closed-end fund's distribution rate with the fund's total return. In general, a distribution rate is calculated by annualizing the most recent amount paid to investors and dividing the resulting amount by either the market price or the fund's NAV. The total return will take into account the change in share price from a specific point in time and the income the fund paid. Total return figures for closed-end funds usually assume all distributions were reinvested in the fund.
You can get information about a closed-end fund's distribution rate from the fund's website, its annual report and company announcements. Every time a fund pays a distribution, it must also provide a written statement about the sources it’s tapping to pay the distribution. In addition, closed-end funds notify investors of the sources once a year in IRS Form 1099-DIV. Pay attention to the sources and amounts reported, because a return of capital has different tax consequences than a distribution of interest income, dividends or capital gains.
Questions to Ask Before Investing in a Closed-End Fund
1. Does a closed-end fund fit into my investment objectives?Ask your investment professional to explain whether and how these complex products might fit with your goals, time horizon and risk tolerance.
2. What’s the fund's investment strategy?The fund's prospectus or most recent annual or quarterly reports will have details about the fund's investment strategies, risks, proposed sources of distributions, intended use of leverage and management costs. You can obtain the prospectus and other company reports on the SEC's EDGAR database, the fund's website or through your investment professional.
3. How much of what I pay per share will be invested? Know the "built-in" sales charge and other expenses for the shares you buy, and understand how much of the price you pay will actually be invested to work for you.
4. What are the tax implications? Like mutual funds, closed-end funds "pass through" tax obligations to investors. Be sure you understand—or consult a tax professional to learn more about—how any distributions you receive will impact the taxes you owe. Remember that you have no control over the timing of distributions, the sources that the fund will use to pay them or the tax treatment that will apply.
5. How is the distribution rate set? Read a fund's prospectus or distribution announcements to gain an understanding of the sources used to make distribution payments and whether the fund follows a managed distribution policy. If you see frequent returns of capital, ask why the fund isn’t generating enough income for distributions. Keep in mind that a fund's current distribution rate isn’t indicative of future distribution rates.
6. Are the shares trading at a premium or discount to NAV? While you might not be able to determine why a closed-end fund's shares are trading at a premium or discount to NAV, be sure to find out—from the closed-end fund's website or exchange where it’s listed—how the price you’re paying compares to the fund's inherent value. This will affect your total return.
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