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By Jim Middlemiss
Bankrate.com
Monday, July 31, 2006
Want to invest in high-yielding, investment-grade debt? Then consider the Citadel HYTES Fund that trades on the Toronto Stock Exchange, or TSX. If that doesn't suit your fancy, how about putting your money in a basket of investment-grade preferred securities, such as the Flaherty & Crumrine Investment Grade Preferred Income Fund or one of the growing number of oil and gas funds or dividend-paying stocks?
Adrian Mastracci, investment counsel at Vancouver’s ‘fee-only’ KCM Wealth Management, says, “Closed End Funds cover a fairly wide variety of investment strategies, such as Canadian equity, bonds and foreign holdings.”
Welcome to the world of the closed-end fund, or CEFs, an investing product that is as flexible as it is varied. "CEFs cover a fairly wide variety of investment strategies, such as Canadian equity, bonds and foreign holdings," says Adrian Mastracci, a fee-only investment counsel at KCM Wealth Management Inc. in Vancouver.
When it comes to investing in funds, most people think their only option is to buy one of thousands of open-ended funds, such as mutual funds, that trade in Canada. But CEFs are a whole other category of investment with additional benefits.
Janis Koyanagi, senior manager of income trusts, structured products and exchange-traded funds at the TSX, says the number of CEFs is growing, with almost 300 now trading on the TSX. Five years ago, there was $12 billion invested in them -- today, that number sits at more than $50 billion. That still makes CEF holdings much smaller than their mutual fund counterparts, which have more than $500 billion invested, but interest in CEFs is definitely growing. Koyanagi notes that the mix of investments held in CEFs have "been stable, mature companies within the income trust side of the business."
How they work
CEFs are similar to open-ended funds in that money managers attract investors to the fund, which has a specific investing mandate. The main difference is that CEFs "are bought and sold like stocks," says Mastracci. "A traditional open-ended vehicle can create as many new units of a fund as new investors want to buy. A CEF trades a fixed number of shares. Hence, it looks and feels more like a company."
A CEF raises a specific amount of money and then trades on a stock exchange based on the value investors give it at the time of a trade. It will often trade at a discount to the actual value of the investments inside the fund, says Manmeet Bhatia, a chartered financial analyst and vice-president of product development at Qtrade Fund Management Inc. in Vancouver. "This brings about an opportunity to seek out bargains but also brings forward the possibility that an investor is paying a premium based on market factors or the perceived quality of the management of the fund."
That's different than a mutual fund, which is open-ended and keeps taking in new assets, investing that money and issuing new units. CEFs are valued at the end of each day, and any trades in units within that fund take place at the end of the day.
Redemption advantage
One of the advantages a CEF has over an open-ended fund is that managers can stay fully invested at all times. Because investors can redeem units in an open-ended fund, fund managers must keep a hoard of cash lying around to satisfy those redemptions. If the markets turn, there can be a run on as investors scramble to the exits, and that can trigger negative tax consequences if a fund manager has to sell holdings to raise cash, Bhatia says.
"In contrast, with a CEF, shares are traded between investors and the manager is never in a situation where he or she must raise cash to fund redemptions. This brings about the potential for greater tax efficiency if the manager maintains a low turnover strategy within the fund."
Lower expenses
"Generally speaking, CEFs have management expenses of less than half those of traditional mutual funds as they are often sold directly to the public and contain no advisor compensation," says Bhatia.
However, he notes, there are trading fees for CEFs, which vary based on how your brokerage charges commissions. Investors with smaller accounts who trade a lot could see their transaction costs eat up part of their holdings.
Leveraging options
Mastracci notes that fund managers who operate CEFs can also use leverage when purchasing investments, which can provide for greater returns.
However, Mastracci says, there are some downsides. While fees may be lower, investors must open a brokerage account to buy or sell CEFs. Such funds also have a short life cycle and only run for about five years. As well, he notes, they are often "thinly traded," generally riskier and may have less information available for investors. "The daily price fluctuations can also be greater than the corresponding open-ended fund equivalent," he says.
Finding information about closed-end funds can be harder than finding data on mutual funds. However, there are good starting points. The Closed-End Fund Association provides info about CEFs in the U.S. Investors can find more information about CEFs trading in Canada on Globefund.com, which provides a regular report on 226 CEFs trading in Canada.
Once you have identified some opportunities, you can then find out more about the investments using public disclosure sites, including System for Electronic Document Analysis and Retrieval, or SEDAR, for Canadian investments and the U.S. Securities and Exchange Commission for U.S. funds.
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