FINRA recently issued an Investor Alert, “Closed-End Fund Distributions: Where is the Money Coming From?” A closed-end fund pools money from investors to buy securities, and, much like a mutual fund, maintains professionally managed portfolios of stocks, bonds or other investments, including illiquid securities. Closed-funds typically offer a fixed number of shares in an initial public offering which then are traded on an exchange. Mutual funds, in contrast, continuously sell newly issued shares and redeem outstanding shares.
FINRA found that closed-end funds may be attractive to investors as a way to generate income when other investments fail to offer what investors seek. FINRA warns, however, that “a fund’s distribution rate is not the same thing as its return–even if the numbers might look similar. And before you invest, be sure you understand where the closed-end fund is getting the money to pay distributions. In some cases, part of the distribution comes from the return of principal.”
FINRA also noted that when investors buy shares in a closed-end fund IPO, they pay a premium, because the fees and expenses paid for the offering come from the capital raised. Thus, if investors purchase shares in a closed-end fund IPO for $10, the actual amount invested will be less than $10 per share. After the IPO, shares of the closed-end fund may be purchased in the secondary market, such as the NYSE or NASDAQ, and investors pay the fees usually charged by their brokers.
FINRA further explained how closed-end funds are valued:
Because closed-end funds trade like stocks, the supply and demand for the shares determines their market price. Both closed-end funds and mutual funds have an inherent net asset value (NAV) that reflects the value of the funds’ underlying assets (less liabilities) divided by the number of shares outstanding. Closed-end funds also have a market price that fluctuates throughout the trading day, and that price may be higher or lower than its NAV. You may get information on a closed-end fund’s current price and NAV on the fund’s website or that of the exchange where it trades. Information on a fund’s portfolio holdings is usually available on the fund’s website and company filings submitted to the Securities and Exchange Commission.
Closed-end funds have historically traded at a discount to NAV–that is, at a market price lower than the fund’s NAV. Some closed-end funds, however, may trade at a premium to NAV–that is, at a market price higher than the fund’s NAV. One reason may be that investors looking for a high distribution rate may be willing to pay that higher market price to get the distributions. In contrast, shares of a mutual fund are always priced based on the NAV, which is set daily at the close of trading.
In addition, like mutual funds, closed-end funds charge investors annual fees and expenses, and use leverage to increase their returns, which can amplify both the fund’s gains and losses. Leverage generally means using borrowed capital, such as employing strategies intended to profit from the normal spread between short-term and long-term interest rates by borrowing money or issuing preferred stock at short-term interest rates and investing the proceeds in longer-term securities that typically pay higher rates of return. Unlike mutual funds, closed-end funds are not impacted by redemptions, and are permitted to hold a greater percentage of illiquid securities in their investment portfolios.
The Investor Alert urges investors to ask the following six questions before investing in a closed-end fund:
- Does a closed-end fund fit into my investment objectives?
- What is the closed-end fund’s investment strategy?
- How much of what I pay per share in an IPO will actually be invested?
- What are the tax implications?
- What are the tax implications?
- Are the shares trading at a premium or discount to NAV?
Sonn Law Group specializes in representing investors (not brokerage firms) in securities arbitration and investor fraud cases throughout the country. Sonn Law Group has represented numerous investors in FINRA arbitration claims against the brokerage firms who sold illiquid, high-commissioned, non-traded investments, including TICs, REITS, promissory notes, and more, who have filed claims against NFP Securities, Inc., and Investors Capital Corp., among others. Sonn Law Group continues to investigate investment claims against other firms and financial advisors regarding illiquid private placement investments.
To learn more, including whether you may have a claim for investments related to the use of margin or other investment losses, please call us at 844-689-5754 or complete our “contact form.”