Open-End Versus Closed-End Funds: An Investors' Puzzle
While the practical difference for investment returns may not be great under normal market conditions, it can become significant at times of market stress. We are discussing the fundamental differences between open-end and closed-end funds with Giles Keating, Head of Research and Deputy Global Chief Investment Officer and Lars Kalbreier, Head of Mutual Funds & ETFs, to help investors solve the riddle.
Investors have many choices when selecting a pooled investment fund: regional versus global, active versus passive, bonds versus equities, famous manager versus start-up, and so on. But one choice can be overlooked: open-end versus closed-end funds. On occasion, this may be the most important issue. Especially for funds investing in illiquid assets such as real estate, small caps, or specialized credits. In such cases, a closed-end fund may be the better structure.
What are the key differences between closed-end and open-end funds?
Closed-end funds have a fixed asset pool. This can grow (or shrink) due to good (or bad) investment performance, but normally no extra capital is added from investors or paid out. An existing investor who wants to exit must sell on the open market to another investor who wants to put money in. In contrast, the assets in open-end funds can change because of shifts in market prices as well as due to net inflows or outflows of capital from investors. When net new money comes in, the manager invests in extra underlying assets, while exiting investors sell units back to the fund manager, who disposes of underlying investments to meet net redemptions.
Would investors experience any difference on the operational level?
Investors in open-end funds buy and sell units at a level equal to the underlying asset value (subject to enough liquidity). By contrast, the price of closed-end funds is typically at a premium or discount to the underlying assets, reflecting the balance between the supply from exiting investors versus demand from those entering.
In closed-end funds, can a premium be a measure of a fund manager's skills?
Academic studies have argued that a premium might reflect the skill of the manager or the rarity of the underlying assets, while a discount might indicate lack of confidence in the manager. Morningstar data shows that, over the long term, closed-end US funds have on average traded at a slight discount. This tends to deepen when markets go down, while it narrows or moves to a premium when markets go up and investors become more optimistic.
Some closed-end funds buy back their own shares to try to narrow the discount, enhancing value for remaining investors. Sometimes, external predators try to gain control and liquidate the fund at the market value, thus effectively eliminating the discount. Despite these measures, discounts and premiums rarely disappear completely, perhaps because demand for most closed-end funds is dominated by retail investors who tend to be procyclical.
Who covers the operational costs in open-end funds?
When money flows in or out of open-end funds, the dealing costs are in many cases spread among all investors. The impact of these costs may be negligible in large funds with little movement, but can be a noticeable burden on performance in small, fast-growing funds. Perhaps, more importantly for an open-end fund with specialist strategies in relatively illiquid assets like small-cap or frontier-market stocks, a good performance in the early years when the fund is small may be difficult to replicate later if large amounts of new money are attracted by the good results, but are not easily investible in the same way. So many successful open-end fund managers in specialist areas close their funds for new investments to protect existing investors as they approach capacity limits. If a manager does not do this, there can be style drift, making the track record of a fund manager less relevant.
What happens when market conditions become averse?
When markets become stressed, such as during the financial crisis, some assets may become illiquid, while others remain easy to sell. When this happens with an open-end fund, the first investors to exit will tend to receive cash obtained by the manager from sales of the more liquid assets. While this is good for these faster-moving investors, slower-moving investors are left with units in an imbalanced fund that holds mainly illiquid assets that cannot be readily sold and for which the theoretical valuation may fall further than the more balanced portfolio existing before the stress began. Well-known examples in recent years include some frontier-market, real estate and credit funds. Fund managers may have some ability to restrict ("gate") withdrawals. If this is done early in the stress situation, it in effect temporarily makes the fund closed, protecting remaining investors. But in a worst-case scenario, this closure happens after the faster investors have left, which leaves remaining investors trapped with a pool of illiquid underlying assets that may then eventually be sold as soon as some limited liquidity reappears, which unfortunately is likely to be near the bottom of the market.
Does it apply to closed-end funds, too?
Clearly, this process simply cannot happen in a closed-end fund. Faster investors who try to exit will likely find few buyers, forcing the fund price down to a substantial discount to the apparent net asset value. In the middle of the financial crisis in early 2009, the average discount of the largest US-listed closed-end funds rose as high as 25 percent. But the fund manager is not forced into selling the underlying assets to meet withdrawals. Investors who are prepared to hold their nerve through the phase of stress will still own a share in the balanced pool of assets selected by the manager, with a good chance of recovery after the stress has passed, and they will not be forcibly liquidated near the bottom of the market by the selling actions of other investors in the fund. Indeed, after the financial crisis, the average discount narrowed quickly as markets recovered, providing an additional return driver for these funds on top of the rise in price of the underlying assets.
What should investors choose: an open-end or a closed-end fund?
The conclusion is that investors should choose between open-end and closed-end funds largely on the basis of the underlying asset type. For investments in mainstream, liquid markets like developed economy large-cap equities, an established large open-end fund is probably the better choice in most cases. It avoids the fluctuating premiums/discounts of closed-end funds and should be large enough to avoid issues of dealing cost attribution, although it would likely not have leverage capability.
In contrast, closed-end funds are likely to be the better choice for underlying assets such as real estate, frontier markets, small caps and low-grade credit, since these are, or are at risk of becoming, illiquid with all the potential issues described above.