22.4.2 Closed-end Funds As Alternative Investment Strategy

Introduction

Closed-end funds have traditionally stood second in popularity only to hedge funds among the investment product structures leveraged by investors eager for exposure to alternative investment strategies. This chapter explores how closed-end funds operate as an alternative investment vehicle, evaluating specific characteristics, advantages, and recent regulatory changes influencing their use.

Mechanics of Closed-end Funds

The structure of closed-end funds lends itself efficiently to alternative investment strategies due to the stability of the capital base; fund managers don’t need to adjust holdings for investor redemptions continually. Because of this, closed-end funds are particularly compatible with illiquid investments such as equity real estate and private equity.

Advantages

1. Stable Capital: Locked-in capital throughout the fund’s life cycle allows managers to commit to less liquid investments.
2. Long-term Horizon: Closed-end funds cater to long-term strategies that other fund structures might eschew due to liquidity concerns.
3. Regulatory Flexibility: Greater allowable limits on illiquid assets compared to alternative mutual funds.
4. Premiums and Discounts: Although they might trade at discounts or premiums to NAV, savvy management can leverage these price movements.

Considerations

Trading at Discounts or Premiums: A unique characteristic of closed-end funds is their tendency to trade at variances from their NAV. Investors and managers must keep this in mind and strategize accordingly.

Regulatory Framework

Mutual Fund Modernization Amendments to NI 81-102

Amendments introduced in 2018 significantly impacted the landscape of closed-end funds by aligning their investment strategies closely with those permissible to alternative mutual funds. Key changes include:

• Restrictions regarding leverage, short selling, the use of derivatives, and portfolio concentration now applicable to closed-end funds, similar to alternative mutual funds.
• More room for illiquid assets: The allowance for illiquid assets in closed-end funds is raised to 20% of NAV, as opposed to the 10% cap stipulated for alternative mutual funds.
• Temporary illiquidity cap set at 25% of NAV for closed-end funds, which can last up to a maximum of 90 days (contrasted with a 15% limit for mutual funds).

Grandfather Clause

Existing closed-end funds are exempt from these modifications provided they do not undertake new public offerings.

Future Prospects

With the delineation between closed-end funds and alternative mutual funds becoming more defined, future developments in how closed-end funds are used to deliver alternative strategies will be closely observed by the market.

Chart: Trends in Closed-end Fund Market (2018-2023)

    graph LR
	    A[2018] -->|Regulatory Changes| B2020
	    B2020 -->|Market Reactions| C2021
	    C2021 -->|Innovation in Strategies| D2023

Glossary of Terms

• Closed-end Fund: An investment fund with a fixed number of shares that trade like stocks on a stock exchange, differing from mutual funds that commonly allow continuous share creations and redemptions.
• Net Asset Value (NAV): The total value of a fund’s assets minus its liabilities, often divided by the number of shares outstanding to give a per-share value.
• Alternative Investment Strategy: Investment approach that departs from traditional equities, bonds, and cash holdings, often characterized by a higher degree of risk and potential return.
• Mutual Fund Modernization (NI 81-102): A set of amendments intended to update the regulatory framework governing mutual funds in Canada, including closed-end funds.

Key Takeaways

1. Structural Advantages: Closed-end funds offer several benefits like stability of capital and flexibility in illiquid investments, making them suitable for alternative strategies.
2. Regulatory Changes: The 2018 amendments to NI 81-102 have harmonized the investment restrictions for closed-end and alternative mutual funds, allowing greater liquidity in closed-end funds.
3. Future Implications: With a clearer regulatory landscape, the market’s response and strategy innovations in closed-end funds will be worth monitoring.
4. Understanding Discounts and Premiums: Knowledge of how these funds trade concerning their NAV is crucial for effective investment management.

Frequently Asked Questions (FAQs)

1. What are closed-end funds? Closed-end funds are investment companies that issue a fixed number of shares that trade on the stock market. They are often used for alternative investment strategies.
2. Why are closed-end funds suitable for alternative investments? Their fixed capital base allows managers to invest in illiquid assets without worrying about redemptions, particularly beneficial for long-term alternative investments like private equity.
3. What regulatory changes were introduced by NI 81-102? The 2018 amendments aligned closed-end funds with alternative mutual funds concerning investment restrictions but provided greater flexibility for illiquid asset limits.
4. How do closed-end funds handle liquidity concerns? As closed-end funds do not permit continuous redemption, they can maintain a stable investment base, permitting investment in less liquid assets.