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60th edition

INVESTMENT COMPANY FACT BOOK

A Review of Trends and Activities in the Investment Company Industry

CHAPTER FIVE

US Closed-End Funds

Closed-end funds are one of four types of investment companies, along with mutual (or open-end) funds, exchange-traded funds (ETFs), and unit investment trusts. Closed-end funds generally issue a fixed number of shares that are listed on a stock exchange or traded in the over-the-counter market. The assets of a closed-end fund are professionally managed in accordance with the fund’s investment objectives and policies, and may be invested in stocks, bonds, and other securities. Total assets of closed-end funds were $278 billion at year‑end 2019.

IN THIS CHAPTER

What Is a Closed-End Fund?

A closed-end fund is a type of investment company whose shares are listed on a stock exchange or traded in the over-the-counter market. The assets of a closed-end fund are professionally managed in accordance with the fund’s investment objectives and policies, and may be invested in equities, bonds, and other securities. The market price of a closed-end fund share fluctuates like that of other publicly traded securities and is determined by supply and demand in the marketplace.

A closed-end fund is created by issuing a fixed number of common shares to investors during an initial public offering. Subsequent issuance of common shares can occur through secondary or follow-on offerings, at-the-market offerings, rights offerings, or dividend reinvestments. Closed-end funds also are permitted to issue one class of preferred shares in addition to common shares. Holders of preferred shares are paid dividends, but do not participate in the gains and losses on the fund’s investments. Issuing preferred shares allows a closed-end fund to raise additional capital, which it can use to purchase more securities for its portfolio.

Once issued, shares of a closed-end fund generally are bought and sold by investors in the open market and are not purchased or redeemed directly by the fund—although some closed-end funds may adopt stock repurchase programs or periodically tender for shares. Because a closed-end fund does not need to maintain cash reserves or sell securities to meet redemptions, the fund has the flexibility to invest in less-liquid portfolio securities. For example, a closed-end fund may invest in securities of very small companies, municipal bonds that are not widely traded, or securities traded in countries that do not have fully developed securities markets.

Total Assets of Closed-End Funds

At year-end 2019, 500 closed-end funds had total assets of $278 billion (Figure 5.1). Total assets increased by more than 10 percent from year-end 2018, driven by rising stock prices around the world, strong returns on bonds, and increased demand for both equity and bond closed‑end funds.

FIGURE 5.1

Total Assets of Closed-End Funds Were $278 Billion at Year-End 2019
Billions of dollars, year-end

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Note: Total assets is the fair value of assets held in closed-end fund portfolios funded by common and preferred shares less any liabilities (not including liabilities attributed to preferred shares).

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Historically, bond funds have accounted for a large share of assets in closed-end funds. At year-end 2009, 61 percent of all closed-end fund assets were held by bond funds, with the remainder held by equity funds (Figure 5.2). At year-end 2019, 61 percent of closed-end fund assets ($171 billion) were held by bond funds. The remaining 39 percent of closed-end fund assets ($107 billion) were held by equity funds. These shares have remained relatively stable, in part because of two offsetting factors. Over the past 10 years, cumulative net issuance of bond closed-end fund shares exceeded that of equity fund shares—offsetting the total returns on US stocks,* which exceeded those of US bonds during this time.

 

* As measured by the Wilshire 5000 Total Market Index.

As measured by the FTSE US Broad Investment Grade Bond Index.

The number of closed-end funds available to investors decreased for the eighth straight year in 2019, and remains well below its recent peak in 2011 (Figure 5.1). Over this period, more closed-end funds were liquidated, merged, or converted into open-end mutual funds or exchange-traded funds (ETFs) than were launched.

FIGURE 5.2

Composition of the Closed-End Fund Market by Investment Objective
Percentage of closed-end fund total assets, year-end

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Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Net Issuance of Closed-End Funds

Net issuance of closed-end fund shares was $5.9 billion in 2019, compared with $1.0 billion in 2018 (Figure 5.3). Both equity and bond closed-end funds had positive net share issuance in 2019—$2.6 billion for equity closed-end funds and $3.2 billion for bond closed-end funds. For equity closed-end funds, the majority of net share issuance went to global/international funds ($1.8 billion), and for bond closed-end funds, net share issuance was divided relatively equally between domestic taxable funds ($1.3 billion) and domestic municipal funds ($1.7 billion), with global/international bond funds receiving $0.3 billion.

FIGURE 5.3

Closed-End Fund Net Share Issuance
Millions of dollars
 EquityBond
 TotalTotalDomesticGlobal/
International
TotalDomestic
taxable
Domestic
municipal
Global/
International
2010 5,430 2,054 1,995 59 3,376 1,900 1,119 357
2011 6,018 4,466 3,206 1,260 1,551 724 825 2
2012 11,385 2,953 2,840 113 8,432 3,249 3,102 2,081
2013 14,515 3,605 4,097 -491 10,909 3,921 530 6,459
2014 4,935 4,314 3,819 494 621 266 567 -212
2015 1,859 1,267 224 1,043 592 708 -11 -104
2016 829 58 242 -184 771 1,437 -168 -498
2017 678 -548 -147 -401 1,226 758 231 237
2018 1,004 -412 -352 -60 1,416 251 1,169 -4
2019 5,862 2,612 808 1,805 3,249 1,311 1,674 265

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Note: Net share issuance is the dollar value of gross issuance (proceeds from initial and additional public offerings of shares) minus gross redemptions of shares (share repurchases and fund liquidations). A positive number indicates that gross issuance exceeded gross redemptions. A negative number indicates that gross redemptions exceeded gross issuance.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Closed-End Fund Distributions

In 2019, closed-end funds distributed an estimated $16.4 billion to shareholders (Figure 5.4). Closed‑end funds may make distributions to shareholders from three possible sources: income distributions, which are payments from interest and dividends that the fund earns on its investments in securities; realized capital gains distributions; and return of capital. Income distributions made up 70 percent of closed-end fund distributions. Capital gains distributions accounted for 10 percent of closed-end fund distributions, and return of capital constituted 20 percent.

FIGURE 5.4

Closed-End Fund Distributions
Percentage of closed-end fund distributions, 2019

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* Income distributions are paid from interest and dividends that the fund earns on its investments in securities.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Closed-End Fund Leverage

Closed-end funds have the ability, subject to strict regulatory limits, to use leverage as part of their investment strategy. The use of leverage by a closed-end fund can allow it to achieve higher long-term returns, but also increases risk and the likelihood of share price volatility. Closed-end fund leverage can be classified as either structural leverage or portfolio leverage. At year-end 2019, at least 320 funds, accounting for 64 percent of closed-end funds, were using structural leverage, some types of portfolio leverage (i.e., tender option bonds or reverse repurchase agreements), or both as a part of their investment strategy (Figure 5.5).

FIGURE 5.5

Closed-End Funds Are Employing Structural Leverage and Some Types of Portfolio Leverage
Number of funds, end of period

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1 Components do not add to the total because funds may employ both structural and portfolio leverage.

2 Structural leverage affects the closed-end fund’s capital structure by increasing the fund’s portfolio assets through borrowing capital and issuing debt and preferred shares.

3 Portfolio leverage is leverage that results from particular types of portfolio investments, including certain types of derivatives, reverse repurchase agreements, tender option bonds, and other investments or types of transactions. Data are only available for reverse repurchase agreements and tender option bonds. Given data collection constraints, and the continuing development of types of investments/transactions with a leverage characteristic (and the use of different definitions of leverage), actual portfolio leverage may be materially different from what is reflected above.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Structural leverage, the most common type of leverage, affects the closed-end fund’s capital structure by increasing the fund’s portfolio assets. Types of closed-end fund structural leverage include borrowing capital and issuing debt and preferred shares. At the end of 2019, 275 funds had a total of $52.2 billion in structural leverage, with 56 percent from preferred shares (Figures 5.5 and 5.6). The remaining 44 percent of closed-end fund structural leverage was other structural leverage, which includes bank borrowing and other forms of debt. The average leverage ratio* across those closed-end funds employing structural leverage was 27 percent at year-end 2019. Among closed-end funds employing structural leverage, the average leverage ratio for bond funds was somewhat higher (28 percent) than that of equity funds (22 percent).

 

* The leverage ratio is the ratio of the amount of structural leverage to the sum of the amount of common share assets and structural leverage.

FIGURE 5.6

Preferred Shares Constituted the Majority of Closed-End Fund Structural Leverage
Percentage of closed-end fund structural leverage, year-end 2019

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1 A closed-end fund may issue preferred shares to raise additional capital, which can be used to purchase more securities for its portfolio. Holders of preferred shares are paid dividends, but do not participate in the gains and losses on the fund’s investments.

2 Other structural leverage includes bank borrowing and other forms of debt.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Portfolio leverage is leverage that results from particular portfolio investments, such as certain types of derivatives, reverse repurchase agreements, and tender option bonds. At the end of 2019, 149 closed-end funds had $20.0 billion outstanding in reverse repurchase agreements and tender option bonds (Figures 5.5 and 5.7).

FIGURE 5.7

Use of Portfolio Leverage
Billions of dollars, end of period

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Note: Portfolio leverage is leverage that results from particular types of portfolio investments, including certain types of derivatives, reverse repurchase agreements, tender option bonds, and other investments or types of transactions. Data are only available for reverse repurchase agreements and tender option bonds. Given data collection constraints, and the continuing development of types of investments/transactions with a leverage characteristic (and the use of different definitions of leverage), actual portfolio leverage may be materially different from what is reflected above.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Closed-End Fund Discounts

About 94 percent of closed-end funds calculate the value of their portfolios every business day, while the rest calculate their portfolio values weekly or on some other basis. The net asset value (NAV) of a closed-end fund is calculated by subtracting the fund’s liabilities (e.g., fund borrowing) from the current market value of its assets and dividing by the total number of shares outstanding. The NAV changes as the total value of the underlying portfolio securities rises or falls, or the fund’s liabilities change.

Because a closed-end fund’s shares often trade in the stock market based on investor demand, the fund may trade at a price higher or lower than its NAV. A closed-end fund trading at a share price higher than its NAV is said to be selling at a “premium” to the NAV, while a closed-end fund trading at a share price lower than its NAV is said to be selling at a “discount.” Funds may trade at discounts or premiums to the NAV based on market perceptions or investor sentiment. For example, a closed-end fund that invests in securities that are anticipated to generate above-average future returns and are difficult for retail investors to obtain directly may trade at a premium because of a high level of market interest. In contrast, a closed-end fund with large unrealized capital gains may trade at a discount because investors will have priced in any perceived tax liability.

Price deviations narrowed significantly in January 2019 after widening at the end of 2018, as expectations of slowing global growth contributed to a decline in financial markets worldwide (Figure 5.8). For the remainder of 2019, price deviations for equity closed-end funds remained relatively stable and price deviations for bond closed-end funds steadily narrowed. For equity closed-end funds, the average discount narrowed from 9.4 percent at year-end 2018 to 6.7 percent by January 31, 2019, and ended the year at 6.3 percent. The average discount for bond closed-end funds narrowed from 9.9 percent at year-end 2018 to 6.5 percent by the end of January 2019, and further narrowed to 3.0 percent by the end of the year.

FIGURE 5.8

Closed-End Funds’ Premium/Discount Rate
Percent, month-end

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Note: The premium/discount rate is the simple average of the difference between share price and NAV at month-end.

Source: Investment Company Institute tabulations of Bloomberg data

Characteristics of Households Owning Closed-End Funds

An estimated 3.0 million US households owned closed-end funds in 2019. These households tended to include affluent investors who owned a range of equity and fixed-income investments. In 2019, 90 percent of households owning closed-end funds also owned equity mutual funds, individual stocks, or variable annuities (Figure 5.9). Sixty-three percent of households that owned closed-end funds also held bond mutual funds, individual bonds, or fixed annuities. In addition, 48 percent of these households owned investment real estate.

FIGURE 5.9

Closed-End Fund Investors Owned a Broad Range of Investments
Percentage of closed-end fund–owning households holding each type of investment, 2019
Equity mutual funds, individual stocks, or variable annuities (total 90
Bond mutual funds, individual bonds, or fixed annuities (total) 63
Mutual funds (total) 86
Equity 80
Bond 45
Hybrid 40
Money market 69
Individual stocks 75
Individual bonds 27
Fixed or variable annuities 34
Investment real estate 48

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Note: Multiple responses are included.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019

Because a large number of households that owned closed-end funds also owned stocks and mutual funds, the characteristics of closed-end fund–owning households were similar in many respects to those of households owning stock and mutual funds. For instance, households that owned closed-end funds (like stock- and mutual fund–owning households) tended to be headed by college-educated individuals and tended to have household incomes above the national median (Figure 5.10).

Nonetheless, households that owned closed-end funds exhibited certain characteristics distinguishing them from mutual fund–owning households. For example, households with closed-end funds tended to have greater household financial assets (Figure 5.10). Also, 30 percent of households owning closed-end funds were retired from their lifetime occupations, compared with 24 percent of households owning mutual funds.

FIGURE 5.10

Closed-End Fund Investors Had Above-Average Household Incomes and Financial Assets
2019
 All US
households
Households
owning
closed-end funds
Households
owning
mutual funds
Households
owning
individual stocks
Median
Age of head of household1 52 55 51 53
Household income2 $62,500 $130,000 $100,000 $110,000
Household financial assets3 $80,000 $450,000 $250,000 $350,000
Percentage of households
Household primary or co-decisionmaker for saving and investing
Married or living with a partner 56 64 68 70
College or postgraduate degree 37 66 54 57
Employed (full- or part-time) 64 70 77 75
Retired from lifetime occupation 28 30 24 27
Household owns
IRA(s) 36 73 65 68
DC retirement plan account(s) 49 61 84 76

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1 Age is based on the sole or co-decisionmaker for household saving and investing.

2 Total reported is household income before taxes in 2018.

3 Household financial assets include assets in employer-sponsored retirement plans but exclude the household’s primary residence.

Source: ICI Research Perspective, “The Closed-End Fund Market, 2019