Closed End Funds and Closed End Fund Advisers
Closed End Fund Solutions
Vigilant’s Closed-End Fund Solutions Group is comprised of experienced and highly qualified professionals with extensive experience in the investment management industry. The Team has served in senior roles for Investment Advisers and Investment Companies (internal positions) as well as senior business advisers for Compliance Consulting and Public Accounting Firms (external positions).
Vigilant’s Closed-End Fund Solutions Group currently serves as Outsourced CCO and CFO providing guidance and advising on regulatory, operational and governance matters that include the following:
- Adviser CCO and CFO Support Services
- Outsourced Fund CCO and CFO Services
- Investment Adviser Compliance and Oversight
- Fund Registration Support
- Service Provider Selection and Due Diligence
- Service Provider Integration and Coordination
A critical component to the effective performance of the CCO function is oversight of Service Providers (Fund Adviser, Fund Accountant, Fund Administrator, Custodian, Transfer Agent, Distributor, and Principal Underwriter). Fund Compliance with the Investment Company Act of 1940, the Securities Exchange Act of 1934, the Securities Act of 1933, and other Regulations takes careful analysis and planning which is a core focus of Vigilant for their Fund clients.
Types of Closed-End Funds Vigilant can Provide CCO and CFO Services for:
Interval Funds and Tender Offer Funds
Interval Funds and Tender Offer Funds represent subsets of Closed-End Funds. These Funds, under Rule 415 and Rule 486 under the Securities Act of 1933 and Rule 23c-3 under the Investment Company Act of 1940, may continuously offer their shares and make offers to repurchase shares at net asset value (NAV).
Equity Oriented Closed-End Funds
All Equity Closed-End Funds are subject to the risk that the portfolio securities held by the Fund will decline in value, thus causing a decline in the Fund’s NAV and market price. The value of a particular stock in a Fund’s portfolio may increase or decrease for a variety of reasons, including the business activities and financial condition of the issuer of the stock, market and economic conditions affecting the issuer’s business, or the stock market generally.
Fixed-Income Oriented Closed-End Funds
All Fixed-Income Closed-End Funds are subject to some degree of market risk and credit risk. Market risk is the risk that interest rates will rise, lowering the value of Bonds held in the Fund’s portfolio. Generally speaking, the longer the remaining maturity of a Fund’s portfolio securities, the greater the volatility of its NAV due to market risk. Credit risk is the risk that issuers of bonds held by the Fund will default on their promise to pay principal and interest. A Bond Closed-End Fund’s investment policies typically define the credit quality and maturity of the investments the Fund may make.
Overview on Closed-End Funds
Closed-End Funds are one of four types of Investment Companies registered under the Investment Company Act of 1940, along with Open-End Funds (Mutual Funds), Exchange-Traded Funds (ETFs), and Unit Investment Trusts. There are two varieties, Publicly Traded and Unlisted, and both are regulated under the Investment Company Act of 1940. Vigilant has decades of experience providing CCO Services to all four types of Investment Companies ranging from Start Up Funds to Multi Billion Funds, both on the Adviser and Fund CCO side.
Publicly Traded (Traditional) Closed-End Funds issue a fixed number of shares through an Initial Public Offering (IPO). Shares of Traditional Closed-End Funds trade on an exchange and, therefore, investors can buy and sell shares of Traditional Closed-End Funds just like a stock.
Unlisted Closed-End Funds typically offer a fixed number of shares over longer periods of time, typically several years. The shares of unlisted Closed-End Funds are not Publicly Traded and limit investment to certain types of investors such as accredited and/or qualified purchasers. Investors may redeem their shares at defined intervals, typically monthly, quarterly, or semiannually. The amount redeemable is normally subject to a cap based on the percentage of shares outstanding.
There are several types of Closed-End Funds with unique characteristics, such as Interval Funds and Tender Offer Funds or Business Development Companies (BDCs).
Unlike Mutual Fund Managers who must worry about constant inflows and outflows of cash, Closed-End Fund Managers are responsible for a stable pool of capital. Although Fund shares trade actively, that doesn’t affect the Fund Manager because no assets are flowing into or out of the portfolio. Therefore, Closed-End Fund Managers can put capital to work in a Long-Term Strategy, without worrying whether their Fund will have enough liquidity to pay back investors who suddenly sell (redeem) shares. This may lead to superior investment results. It also makes the Closed-End Fund Structure advantageous for investing in specialized areas such as less Liquid Securities or Markets, Venture Capital Opportunities, Real Estate, and Private Placements. Regardless of the trading volume or market price fluctuations in such areas, Closed-End Fund Managers are never forced to sell securities in a declining market to meet redemptions. Conversely, in a bull market, Closed-End Fund Managers aren’t inundated with new cash.
Closed-End Funds share many operational, governance, regulatory and distribution characteristics with Open-End Funds and ETFs but also differ from Open-End Funds and ETFs in a number of ways that may be advantageous or disadvantageous. With that being said, choosing the type of vehicle to use to distribute Adviser’s unique investment portfolio strategies will have a significant impact on the Adviser’s ability to market and distribute investment management products to the marketplace.
- 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 Alternative Assets.
- Both make distributions of income and capital gains to their shareholders. Both charge an annual expense ratio or their services. Moreover, the companies that offer them must be registered with the Securities and Exchange Commission (SEC).
- The market price of Closed-End Fund shares fluctuates like that of other Publicly Traded Securities and is determined by supply and demand in the marketplace. 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 to raise additional capital, which it can use to purchase more assets for its portfolio. Holders of preferred shares are paid dividends, but do not participate in the gains and losses on the fund’s investments.
- 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.
- 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.
- Once issued, Traditional Closed-End Funds generally issue a fixed number of shares to investors during an IPO that are listed on a stock exchange or trade in the over-the-counter market. Closed-End Funds generally are bought and sold by investors in the open market and are not purchased or redeemed directly by the Fund, however, Closed-End Funds may adopt stock repurchase programs (Interval Funds) or periodically tender for shares (Tender Offer Funds).
8 Trends for Closed-End Funds
- At year-end 2022, 441 Exchange-Listed Closed-End Funds had total assets of $252 billion.
- A. By comparison, at year end 2017, 532 Exchange-Listed Closed-End Funds had total assets of $277 billion.
- Historically, Fixed-Income Oriented Funds have accounted for a large share of assets in Exchange-Listed Closed-End Funds; and at year-end 2022, total assets in Exchange-Listed Fixed Income Oriented Closed-End Funds were $153 billion, or 61% of Exchange-Listed Closed-End Fund assets.
- At year-end 2022, total assets in Exchange-Listed Equity Closed-End Funds were $99 billion, or 39% of Closed-End Fund total assets.
- Interval Funds are the preferred Unlisted Closed-End Fund structure. The market share has grown from 19% at year-end 2014 to 53% as of March 2020.
- Interval Funds are also the focus of product development, accounting for 84% of product launches over the last three years.
- Strategies focused on accredited investors continue to account for the majority of Unlisted Closed-End Fund assets with 61% market share.
- Unlisted Closed-End Funds are an emerging product structure with $62 billion in Assets Under Management. Product Manufacturers will need to actively market their products to manage reservations about the overall structure (limited liquidity, fees, track records).
- During the last three years, Unlisted Closed-End Funds grew at an annual rate of 19%, 12% and 22%, respectively.
Unlisted Closed-End Funds provide access to Alternative Investments that have traditionally only been provided by high cost, exclusive Private Funds. It comes to no surprise that the Closed-End market trends include:
- Access to Illiquid Asset Classes and Alternative Strategies
- Conversions of Hedge Funds and Private Equity
- Investments in Direct Credit Facilities
- Interval Funds are the preferred unlisted Closed-End Fund Structure
7 Factors to Consider for Closed-End Funds
More than 95% of Exchange-Listed Closed-End Funds calculate the value of their portfolios every business day, while others calculate their portfolio values weekly or on some other basis. The NAV of a Closed-End Fund is calculated by subtracting the Fund’s liabilities (e.g., Fund expenses) 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 an Exchange-Listed Closed-End Fund’s shares 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 trading at a “premium” to the NAV, while a Closed-End Fund trading at a share price lower than its NAV is said to be trading at a “discount.” Funds may trade at discounts or premiums to their NAVs 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.
Fund Management may take measures in an attempt to reduce discounts, including increasing market visibility of the Fund through public reports and communications. A Closed-End Fund also may attempt to increase the demand for its shares by offering a dividend reinvestment plan, engaging in Tender Offers (the Fund offers to purchase its shares directly from shareholders at, or close to, NAV), or instituting a stock purchase program (the Fund purchases its shares on the open market). Further, some Closed-End Funds periodically may consider converting to either an Open-End Fund (Mutual Fund) or an Exchange-Traded Fund (ETF), which would permit shareholders to redeem their shares at NAV.
Of course, any such measures must be approved by the Fund’s Board of Directors as consistent with the best interests of the Fund.
A Closed-End Fund’s investment return has two primary components:
- Share price appreciation or depreciation:
- A Closed-End Fund’s share price may increase or decrease based on market perceptions about the types of securities or geographic region in which the Fund invests and perceptions about the Fund or its Investment Manager.
- A Closed-End Fund makes up to three types of distributions to shareholders: (1) Ordinary Dividends, (2) Capital Gains, and (3) Return of Capital. Some Closed-End Funds follow a managed distribution policy, which allows them to provide predictable, but not guaranteed, cash flow to common shareholders. The payment from a Fund pursuant to a managed distribution policy is typically paid to common shareholders on a monthly or quarterly basis. Managed distribution policies are used most often in Multi-Strategy or Equity-Based Closed-End Funds.
- Ordinary Dividends: A Closed-End Fund earns interest and dividend income from securities held in its portfolio. This income, minus Fund operating costs, typically is paid to shareholders as ordinary dividend distributions.
- Capital Gains: If a Fund profits from selling securities during a calendar year, the Fund may distribute the gains to investors. Distributions of capital gains typically occur annually near the end of the calendar year. Some Funds, particularly those with managed distribution plans, distribute capital gains more frequently.
- Return of Capital: A Closed-End Fund may return capital back to shareholders. Return of capital may occur in a variety of circumstances, including when a Fund is acting as a pass-through. In that circumstance, one or more of its underlying holdings had a return of capital (usually true for master limited partnerships) and the Closed-End Fund is merely passing this payment through to its shareholders. In other circumstances, a Closed-End Fund with a managed distribution policy may return capital to maintain a stable regular distribution that, over the long term, matches the Fund’s distributions to its total return.
In order to avoid the imposition of Federal Tax at the Fund level, a Closed-End Fund must meet Internal Revenue Service (IRS) requirements for sources of income and diversification of portfolio holdings and must distribute substantially all of its income and capital gains to shareholders annually.
Generally, shareholders of Closed-End Funds must pay income taxes on the income and capital gains distributed to them. Each Closed-End Fund will provide an IRS Form 1099 to its shareholders annually that summarizes the Fund’s distributions. When a shareholder sells shares of a Closed-End Fund, the shareholder may realize either a taxable gain or a loss.
Closed-End Funds are regulated under federal laws designed to protect investors. The Investment Company Act of 1940 requires all funds to register with the SEC to meet certain operating standards and to deliver information to investors; the Securities Act of 1933 requires registration of the Fund’s shares and the delivery of a prospectus to investors who purchase shares in the IPO; and the Securities Exchange Act of 1934 regulates the secondary market trading of the Fund’s shares and establishes antifraud standards governing such trading. Finally, the Investment Advisers Act of 1940 regulates the conduct of Fund investment managers and requires them to register with the SEC.
All US-Registered Closed-End Funds are subject to stringent laws and oversight by the SEC and the exchanges on which their shares are listed. All Funds must provide a written prospectus containing complete disclosure about the Fund when its shares are initially offered to the public. Following the IPO, other disclosure documents, including the Annual and Semi-Annual Reports and the Proxy Statement, provide information to investors.
The SEC conducts inspections of Fund operations to determine compliance with applicable laws and SEC regulations. Stock Exchanges on which a Fund’s shares are listed also impose certain requirements. Stock Exchanges require the prompt public disclosure of material information and require certain corporate governance and management procedures, including annual shareholder meetings.
Periodic reports, proxy statements, and, in some cases, Fund Registration Statements, can be found on the website of the Securities and Exchange Commission (SEC) at www.sec.gov.
In absolute terms, net returns, not fee levels, ultimately drive the growth of an investor’s wealth. However, fees are an important consideration in any investment, but they must be understood within their proper context. Market pressures determine the level of fees charged by different fFund Structures and Strategies. The fee structure of Publicly Traded Closed-End Funds that invest in liquid assets will vary from the fee structures of Unlisted Closed-End Funds that invest in Alternative Investments.
A Closed-End Fund incurs operating expenses, including those associated with Fund Portfolio Management, Fund Business Operations, Custody of the Fund’s assets, and shareholder services. These operating expenses are paid by the Fund from its assets before any distributions are made to investors. A Fund’s expenses are summarized in a fee table included in the Fund’s prospectus. Updated expense information is provided in the Fund’s Semi-Annual and Annual Reports to shareholders.
Closed-End Fund shares are bought and sold in the same way one would buy corporate stocks, through Registered Broker Dealers.
During the IPO, a fixed number of Closed-End Fund shares are offered to investors. After the IPO, an investor may purchase shares of existing Closed-End Funds in the secondary market.
In an IPO, a Closed-End Fund’s shares typically are sold subject to a sales charge that is paid to the Underwriter and the Broker-Dealer who sells the shares. A Closed-End Fund investor buying or selling shares in the secondary market likely will pay a sales commission to a Broker at the time of the transaction. The purchase or sale price for shares reflects the current market price, adjusted for the brokerage commission.
The Annual and Semi-Annual Reports that Closed-End Funds provide to shareholders contain financial statements and information on the Fund’s portfolio, performance, and investment goals and policies. A Fund’s Annual Report contains financial statements that have been audited by the Fund’s Independent Public Accountants and Management’s discussion of Fund Operations, Investment Results, and Strategies. In addition, a Fund or an Investor’s Broker may provide statements that update and summarize individual account holdings and values.
The SEC adopted an expansive final rule in March 2020, Securities Offering Reform for Closed-End Investment Companies, designed to streamline reporting and improve the registration process for Closed-End Funds. These Funds, including Business Development Companies (BDCs), register with the SEC by filing on Form N-2. The SEC adopted key Inline XBRL requirements for Closed-End Funds which will modernize their disclosure and benefit both shareholders and the Commission. The rule implements several provisions with staggered compliance dates.
Several elements of the rule took effect initially on August 1, 2020, including:
- Funds can qualify for special status which provides benefits similar to S-3 shelf status used by corporate issuers.
- “Seasoned Fund”
- Current and timely filings
- Public float of $75 million or more
- These funds can file a short form N-2 and conduct takedowns from the shelf registration statement.
- Well-Known Seasoned Issuer (“WKSI”)
- Current and timely in their filings
- Public float of $700 million or more
- WKSI funds can file an automatic shelf registration statement (N-2ASR), conduct takedowns from the shelf offering, and delay fee payments.
- Many Funds are eligible to incorporate information by reference from their periodic reports into their registration statements for the first time, reducing disclosure costs and repetitive information.
- “Seasoned Fund”
The following items became effective on August 1, 2021:
- Ability to file Form 24F-2 (for Fund fees) by Interval Funds.
- Historically, Closed-End Funds were required to pay registration fees upfront, prior to their registration statement (N-2) becoming effective.
- The rule allows Interval Funds to reconcile their fees at the end of each fiscal year and pay registration fees on net new shares, similar to how Mutual Funds and Exchange Traded Funds (ETFs) have paid the SEC for years.
- This will require Interval Funds to file on Form 24F-2 within 90 days of the Fund’s fiscal year end.
- The SEC included a provision in the final rule to account for shares that had already been registered but remained unsold at the time of the transition to filing on Form 24F-2. Those shares should be excluded from the calculation on the form.
- An initial N-2 registration statement, filed by a Non-WKSI Eligible Fund, requires fee payment (EDGAR fee tags). The SEC modified the N-2 submission header to accommodate the new fee payment option for Interval Funds. EDGAR was revised to include a tag in N-2 filings ‘Is Fund 24F-2 Eligible.” When set to ‘Yes,” then no fee tags are required for the filing.
- New Requirement for Closed-End Funds to include a “Management Discussion of Fund Performance”(MDFP) in their Annual The MDFP is already reported by Mutual Funds and ETFs which is filed in their N-CSR. This requirement is similar to the Management Discussion and Analysis (MD&A) filed by corporate issuers in their 10-K or 20-F Annual Report.
- This requirement impacts any N-CSR filing submitted on or after August 1st, 2021, regardless of the fiscal year end.
The SEC adopted significant changes in the final rule that will require Closed-End Funds in the next year to report key information in Inline XBRL format and file Form 24F-2 in XML format (February 1, 2022). Watch for future posts as we explore those in more detail.
Vigilant is a full service Investment Management Solutions Firm servicing the regulatory needs of a diversified range of investment management clients. With team members in New York, Philadelphia, Texas, Metro Washington, D.C., and around the nation, Vigilant is well positioned to help your business create and sustain an effective compliance policy. Since 2004, Vigilant has been the leader among regulatory compliance consulting firms; uniting regulatory compliance, legal, financial expertise and now paving the way to the Market for our clients.