Understanding Closed-end Funds
Closed-end funds are investment funds that have a fixed number of shares and are traded on the open market like stocks. While they offer certain advantages, it’s important to be aware of their disadvantages, particularly in comparison to open-end funds. Here’s an in-depth look at their drawbacks:
Trade at a Discount to NAVPS
- Lack of Essential Parity with NAVPS: Unlike open-end funds, closed-end funds do not necessarily trade at the Net Asset Value Per Share (NAVPS). In bear markets, as the value of the underlying assets declines, the gap between the discount and the NAVPS widens. This can result in closed-end unitholders or shareholders experiencing losses.
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title NAVPS Misalignment
"Trades at Discount": 60
"Trades at Premium": 40
- Volatility: Closed-end funds may trade for extended periods at prices that do not reflect their intrinsic or true value. This creates a layer of uncertainty and market dependency.
Reduced Liquidity
- Market Dependency: Closed-end funds are less liquid compared to open-end funds. They rely on finding buyers and sellers in the open market, as the fund itself does not usually issue or redeem units.
- Transaction Costs: Commissions are paid both at the time of purchase and sale, adding to investment costs.
Higher Commissions and Fees
- Sales Commission: Unlike the deferred sales charge (DSC) option available on many open-end funds, closed-end funds have no schedule of declining redemption fees. If closed-end shares appreciate, the commission payable on the sale could be higher than it was at the time of purchase, as it would be based on the share’s ending value.
Reinvestment Challenges
- Automatic Reinvestment: Many closed-end funds do not offer automatic reinvestment of distributions. Therefore, unitholders need to proactively reinvest cash that builds up in their accounts, unlike open-end funds, which often provide this feature as standard.
Tax Implications
- Dividend Taxation: For closed-end funds that trade on foreign exchanges, any dividend income earned is considered foreign income and is therefore not eligible for the federal dividend tax credit.
Frequently Asked Questions
What is the primary difference between open-end and closed-end funds?
Open-end funds continuously issue and redeem shares at the NAVPS, whereas closed-end funds have a fixed number of shares and trade on the open market.
Why are closed-end funds less liquid than open-end funds?
Open-end funds allow for continuous issuance and redemption, providing inherent liquidity. Closed-end fund transactions depend on finding market buyers and sellers.
What kind of additional costs can I expect with closed-end funds?
Expect to encounter broker commissions on purchase and sale, as well as potentially higher sales commissions if the share value appreciates.
Are there any tax benefits for holding closed-end fund shares?
No, particularly with foreign-traded closed-end funds, dividends are classified as foreign income and are not eligible for the federal dividend tax credit.
Key Takeaways
- Trading at Discount: Closed-end funds often trade at discounts to NAVPS, especially in bear markets.
- Liquidity Concerns: Less liquidity compared to open-end funds, coupled with transaction costs.
- Higher Commission: No declining redemption fees, potentially higher sale commissions.
- Reinvestment Responsibility: Lack of automatic reinvestment options.
- Tax Implications: Dividends from foreign-traded closed-end funds are not eligible for federal dividend tax credit.
Glossary
- NAVPS (Net Asset Value Per Share): The value per share of a fund, calculated by dividing the total net asset value by the number of shares outstanding.
- Liquidity: The ease with which an asset can be converted into cash without affecting its market price.
- Deferred Sales Charge (DSC): A fee paid when selling mutual fund shares, typically decreasing over time.
- Dividend Tax Credit: A non-refundable credit that applies to the dividends earned by residents of the country.
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📚✨ Quiz Time! ✨📚
## What is a major disadvantage concerning the trading price of closed-end funds compared to open-end funds?
- [ ] They always trade above the NAVPS (Net Asset Value per Share)
- [ ] They are guaranteed to trade at their intrinsic value
- [x] They do not necessarily trade at NAVPS
- [ ] They frequently trade at a premium
> **Explanation:** Unlike open-end funds, closed-end funds do not necessarily trade at their net asset value, and in bear markets, this discrepancy can widen, causing potential losses for shareholders.
## How does the liquidity of closed-end funds compare to open-end funds?
- [x] Closed-end funds are generally less liquid than open-end funds
- [ ] Closed-end funds are more liquid than open-end funds
- [ ] Both have similar liquidity
- [ ] Liquidity is not a concern for closed-end funds
> **Explanation:** Closed-end funds require buyers and sellers to be found in the open market without direct issuance or redemption of units by the fund, resulting in lower liquidity compared to open-end funds.
## What downside exists for shareholders of closed-end funds related to commission fees?
- [ ] Commissions are only paid at the time of purchase
- [x] Commissions may be higher at the time of sale if the share value appreciates
- [ ] No commissions are involved with closed-end funds
- [ ] Commissions are constant and do not change
> **Explanation:** Closed-end funds do not have a declining schedule of redemption fees, and if the share value appreciates, the commission payable upon sale could be higher than at purchase time.
## What do closed-end funds typically lack that is a common feature of many open-end funds?
- [x] Automatic reinvestment of distributions
- [ ] Commission fees
- [ ] Dividend payments
- [ ] Participation in foreign exchanges
> **Explanation:** Many closed-end funds do not provide automatic reinvestment of distributions, unlike most open-end funds, placing the responsibility on unitholders to reinvest cash distributions.
## What is a tax-related disadvantage of holding closed-end funds that trade on foreign exchanges?
- [x] Dividend income earned is considered foreign income and not eligible for the federal dividend tax credit
- [ ] Capital gains are more heavily taxed
- [ ] All income is considered tax-exempt
- [ ] Reinvested dividends are taxed twice
> **Explanation:** Dividend income from closed-end funds traded on foreign exchanges is considered foreign income and does not qualify for the federal dividend tax credit, potentially leading to higher taxes.
## Why might the gap between the discount and the net asset value of closed-end funds widen in bear markets?
- [ ] Increased issuance of new units by the fund
- [x] Decline in the value of underlying assets causing market discounts to expand
- [ ] Improved market conditions increasing demand
- [ ] Better liquidity reducing discrepancies
> **Explanation:** In bear markets, the declining value of underlying assets can widen the gap between the actual trading price and the net asset value, leading to greater discounts.
## Why might closed-end funds trade for extended periods at prices not reflecting their intrinsic value in Canada?
- [ ] High demand for closed-end funds
- [x] Limited usage of closed-end funds in Canada
- [ ] Instantaneous redemption of units
- [ ] Strong market regulations guaranteeing intrinsic value
> **Explanation:** Because closed-end funds are not widely used in Canada, they may trade for extended periods at prices that do not accurately reflect their intrinsic value.
## Which costs do closed-end fund investors face both at purchase and sale?
- [x] Commissions
- [ ] Redemption fees
- [ ] Management fees
- [ ] Exchange fees
> **Explanation:** Closed-end fund investors incur commissions both at the time of purchase and at the time of sale.
## How are closed-end funds typically bought and sold?
- [ ] Directly from the fund issuer
- [ ] Through automatic reinvestment plans
- [x] On the open market
- [ ] Via mutual fund dealers
> **Explanation:** Unlike open-end funds, closed-end funds are typically bought and sold on the open market where buyers and sellers must independently locate each other.
## Which of the following features is generally unavailable with closed-end funds compared to open-end funds?
- [x] Deferred sales charge option
- [ ] Capital appreciation potential
- [ ] Dividend payments
- [ ] Transparent pricing mechanisms
> **Explanation:** Closed-end funds do not offer a deferred sales charge option with a schedule of declining redemption fees, a feature often available with open-end funds.