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How cash can clash with your investment goals
It seems like every time you listen to a financial pundit, you hear another new theory about how much cash is too much to hold in your portfolio right now. Whichever theory is correct, most may agree that there’s one time when you probably don’t want to own too much cash—and that’s when you don’t even realize you’re doing it. Chances are, if you own traditional open-end mutual funds, you may own more cash than you know. If that bothers you, you may want to take a closer look at closed-end funds.
Understanding the two types of funds: Closed vs. open
Both open- and closed-end funds let you invest in a portfolio of securities with a single purchase of shares. After that, though, the features of the two kinds of funds start to diverge.
Open-end funds can issue an infinite number of shares. When you invest in an open-end mutual fund, you’re actually purchasing a freshly minted share directly from the fund itself. When you sell or “redeem” your shares, the fund buys back your shares and removes them from circulation. Either way, the share price is set by the fund’s “net asset value,” or NAV—the net value (i.e., assets minus liabilities) of all the securities the fund owns, divided by the total number of shares, as of the end of that trading day.
By contrast, a closed-end fund issues a set number of common shares during its IPO. To invest after the IPO, you purchase existing common shares on the open market from someone else, just like a stock or ETF. You can follow a closed-end fund share price as it changes throughout the day, and when you’re ready to sell, you’ll sell on the exchange to a willing buyer at the going market price. Share prices are set by supply and demand—no matter what the underlying portfolio of assets is worth. As with a stock or ETF, investors can use limit orders to specify the price at which they want to buy or sell shares.
From this one difference—the way you buy and sell shares—flow many other distinctions between the two types of investment vehicles. Including the way they handle cash.
When cash can weigh you down
Open-end funds need to keep cash on hand to cover redemptions. When you want to sell your shares, you expect to receive cash right away. Your fund can’t tell you to wait a week until it has enough money to pay you; the money must be readily available. In the same way, when you want to buy shares in an open-end fund, the fund has to accept your investment promptly, but may not invest it immediately if there aren’t attractive opportunities. In both cases, cash dilutes the amount of exposure the portfolio has to its chosen strategy. For this reason, excess cash can act as a drag on portfolio performance (both upward and downward).
On the other hand, a closed-end fund doesn’t need cash to meet redemptions because investors don’t redeem their shares directly from the fund. Shareholders who want out simply sell their shares on an exchange to another buyer. With little to no excess cash to dilute their portfolios, closed-end funds can maintain their exposure to the investment strategy—increasing their risk-and-reward profile as well.
Freedom to invest in a broader opportunity set
In addition, without shareholder cash entering or leaving the fund, closed-end fund managers have the benefit of a relatively stable pool of assets. That enables them to pursue strategies that may not be available to traditional mutual funds. For example, they can invest in more illiquid assets like real estate that may offer particularly attractive income potential. They can make greater use of leverage to magnify fund performance (both up and down). Of course, like any investment manager, closed-end fund managers will face periods of price corrections and volatility—but at least they can do it without having to sell off assets at fire-sale prices to raise cash if shareholders decide to make a rush for the exits.
Closed-end funds offer income investors some unique potential advantages, including freedom from having to hold excess cash and the benefits of a relatively stable pool of assets.
As more investors begin to clamor for higher, more reliable income, many are rediscovering the potential of closed-end funds. Thanks to some unique structural features—including a relatively stable and fully invested pool of assets —closed-end funds offer income investors some distinct potential advantages. It is important to note that the similarities and differences of closed-end funds versus open-end mutual funds highlighted here are not all inclusive. Investors should consult with their financial professional for more information, and can view: How do CEFs Compare to Other Investment Vehicles.
Risks and disclosures
It is important to consider the objectives, risks, charges and expenses of any fund before investing. Investing in closed-end funds involves risk; principal loss is possible. There is no guarantee a fund’s investment objective will be achieved. Closed-end fund shares may frequently trade at a discount or premium to their net asset value (NAV).
Closed-end fund historical distribution sources include net investment income, realized gains, and return of capital. Leverage increases return volatility and magnifies a fund’s potential return whether that return is positive or negative. There is no guarantee a fund’s leveraging strategy will be successful. All investments carry a certain degree of risk and there is no assurance that an investment will provide positive performance over any period of time.
Nuveen Securities, LLC., member FINRA and SIPC