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Love Me, Love Me Not? Finding the Right Fund Match

02/14/2014

When it comes to choosing open-end mutual funds versus closed-end funds, investors seek distinctly different qualities from each type of investment. Although there are considerably more open-end mutual funds on the market, closed-end funds span a vast array of investment objectives, albeit with a bias toward income-generating strategies.

In screening prospective funds, whether closed- or open-end, beauty truly is in the eye of the beholder. Certain attributes that rank highly for mutual fund investors are at the bottom of the list for closed-end aficionados and vice versa. Adding to the attraction, each fund structure offers special attributes the other does not. In the spirit of this month’s Valentine’s theme and finding one’s “match,” let’s take a closer look at the selection process for open- and closed-end funds to see what appeals most to investors, ranked in order of importance.

Preferred Ranking

Open-End Mutual Funds

Closed-End Funds

#1

Performance
Open-end fund investors generally gravitate to funds that have displayed superior performance, both long- and short-term, often selecting sectors that are currently in vogue.

Valuation
Closed-end fund investors often start by comparing the fund’s discount or premium to its net asset value (NAV), looking for suitable candidates among the most discounted funds within the desired asset class group. Investors who are bullish on a fund have the opportunity to profit not only if the underlying sector does well, but to receive an added gain if or when the discount narrows.

#2

Third-Party Fund Ratings
Various rating services rank funds – such as Morningstar’s widely recognized and respected five-star system – based largely on past performance and risk metrics.

Yield or Distribution Rate
How much does the fund pay out and what are the distribution components – net investment income, short-term gain, long-term gain, or return of capital? The distribution rate is based on the share price paid, so the deeper the discount, the higher the payout rate. The closed-end structure is particularly suited to strategies that enhance income to common shareholders, resulting in larger distributions than similarly invested open-end funds or even direct investment in the underlying securities.

#3

Expense Ratio
Open-end fund investors are highly sensitive to the impact of a fund’s operating expenses on their returns, and understandably favor funds with lower expense ratios.

Leverage
Closed-end funds’ fixed capitalization and the ability to issue senior securities allow for greater and more flexible uses of leverage. Many funds use leverage to magnify performance (both good and bad) but more commonly to boost income. Income-focused funds do so by using a leveraging instrument whose cost is based on short-term interest rates while investing the proceeds in securities that pay interest tied to higher long-term rates. This strategy relies upon a normal, upward sloping yield curve.

#4

Volatility
The volatility of open-end funds is measured by NAV volatility using the key metrics of standard deviation and, in the case of interest rate-sensitive funds, portfolio duration. Higher standard deviation suggests greater risk so investors tend to prefer lower measures. Nevertheless, higher deviations may be acceptable and even desirable to investors who can tolerate it. Duration measures how strongly a fund’s NAV will react to a change in interest rates; the higher the number, the greater the reaction.

Liquidity
A closed-end fund’s number of outstanding shares is fixed at the time of the initial public offering (with limited ways to increase or decrease that number during the fund’s life). Shares then trade on the stock exchange; however, for particularly small funds, even a modest size transaction may move the market. Institutional investors, in particular, favor larger funds that can provide the needed liquidity to accumulate, and later sell, a meaningful position. Even individual investors are more inclined to trade closed-end funds than open-end funds; indeed, that is part of their appeal. Closed-end fund investors can buy and sell intraday, while open-end fund investors may only purchase or redeem shares once a day at the closing NAV.

#5

Yield or Distribution Rate
For funds with an income component, open-end fund investors place an emphasis on how much the fund distributes and how often payouts are made. Distribution size expectations are typically more moderate than for closed-end funds. Unlike for closed-end funds, many open-end fund investors opt for reinvestment.

Volatility
Closed-end funds are inherently more volatile than their open-end counterparts. First, because the leverage used by closed-end funds will magnify NAV fluctuations. Second, because the share price moves independently from NAV, i.e., selling sparked by negative news may not only put pressure on the value of underlying holdings, but may also widen the fund’s discount.

#6

Turnover Ratio
This refers to how actively the portfolio is traded and is directly proportional to underlying transaction costs, which are embedded in the expense ratio. Turnover ratio is a prominently presented statistic for open-end funds. In investors’ eyes, low turnover is preferable to high turnover.

Potential Activism
Some closed-end fund investors monitor the shareholdings of institutional investors for potential dissident activity that may result in discount narrowing. While passive shareholders, such as Unit Investment Trusts (UITs), are restricted in the way they can vote their proxies at shareholder meetings, activist investors may seek to take a dissident stance and push the fund to take action in an attempt to narrow a persistently wide discount.

#7

Investment Manager
Name recognition is particularly important among open-end fund investors. Some are loyal to one asset management group, selecting several different funds under the same advisor’s umbrella.

Expense Ratios
Similar to the impact on open-end funds, expenses to run a closed-end fund cut into NAV performance. However, since closed-end fund investors experience the price performance rather than NAV performance, they tend to put a much lower level of importance on expense ratios than their open-end fund counterparts.

#8

Sales Charge
The transaction cost to buy an open-end fund is the sales charge – often the final factor in the decision-making process. Funds have various ways to assess them: no-load, front-end load, and back-end load. Investors tend to have preferences as to which fee structure they prefer and open-end funds offer several share classes (often A, C, and I) with different sales charges to accommodate them. Once a fund is selected, the last consideration for the investor is which share class to buy.

Performance
As important as past performance is to open-end fund investors, it is surprisingly less critical to closed-end fund investors. The discount/premium pricing of closed-end funds actually reinforces a contrarian view. Closed-end fund traders often select out-of-favor funds at wider discounts as these have the potential to turn in stronger price performance when sentiment shifts and discounts narrow.

What’s Your Type?
Ultimately, finding the right fund match is a matter of personal preference, and devotees of open- and closed-end funds bring a particular perspective bias to their chosen type. A better understanding of these preference hierarchies can benefit both fund managements and investors. For instance, fund managements equipped with this insight can tailor their websites, fact sheets, payout policies, and other crucial decisions to match investor needs and desires.

On the other hand, investors who invest in only one type of fund structure may be missing potential opportunities. For instance, investors new to closed-end funds tend to approach the industry with an open-end mindset and are prone to mistakes such as placing market versus limit orders for illiquid funds, buying popular funds at unsustainable large premiums, or failing to factor in the added volatility and risk associated with leverage.

Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.