Investment Strategies

Give closed-end funds a closer look

Morningstar data suggest they outperform open-end funds in up markets and over time

Jun 22, 2014 @ 12:01 am

Robert Kenyon, managing director for business development at Virtus Investment Partners.
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Robert Kenyon, managing director for business development at Virtus Investment Partners.

Closed-end funds have been on the market since 1893, more than 30 years longer than the first open-end mutual fund. Nevertheless, demand for closed-end funds is not nearly as great.

At year-end 2013, there were 599 closed-end funds, down from a high of 663 in 2007, with $279 billion in assets under management, compared with 7,707 open-end funds with more than $15 trillion in AUM.

Despite their lower profile, closed-end funds deserve to be on investors' radar due to their performance potential. Theoretically, the absence of asset flows, more liberal employment of leverage to enhance returns, and the potential for narrowing of the net asset value discount are reasons why closed-end funds should outperform open-end funds, in up markets and over time. (In down markets, many closed-end funds will underperform due to their heavier use of leverage.)

Unfortunately, proving the theory is problematic. Apples-to-apples fund comparisons are difficult to find but not impossible. Morningstar analyst Steve Pikelny found two comparable high-yield funds, one open-end mutual fund, the other a closed-end fund that eschewed leverage.

In the second quarter of 2013, following the Fed's taper announcement, the mutual fund experienced substantial outflows. The closed-end fund did not, due to its structure. At the end of the 2013 second quarter, the year-to-date return for the mutual fund was 3.6% versus 4.7% for the closed-end fund on a net asset value basis. Mr. Pikelny says both funds were “fairly junky” and therefore illiquid, which apparently hurt the mutual fund when it had to meet redemptions. While limited, “this was a good comparison because you find very few examples of similar funds,” he reports. “The comparison allowed us to isolate the effects of flows on performance.”

The closed-end fund went from trading at NAV to around an 8% discount by midyear. “Investors still did better on an NAV basis, but they probably would have been better off in an open-end fund because of the gap,” Mr. Pikelny says. For the investor who bought that high yield closed-end fund after it gapped, the discount to NAV eventually could accrue to their benefit if and when the gap narrows. This comparison supports the case that a closed-end fund's features should lead to better performance on an NAV basis over time.

Of course, one fund comparison does not proof make. To make a valid argument would require a sizable universe of closed- and open-end funds with similar objectives, asset classes, managers, styles and so on. Unfortunately, that universe does not exist. However, we can take a broader view using Morningstar fund categories to gain insight into the relative performance of the two fund types.


Morningstar maintains performance data on open-end funds in 103 categories, with closed-end funds competing in 76 of them. Because we see closed-end funds as long-term investments, we looked at 25 categories that had at least seven closed-end funds with five- and 10-year histories through Dec. 31, 2013. We compared both types of funds on a total-return-to-NAV basis to see whether the features of closed-end funds enhanced performance.

Over the last five years, which was a generally up market, closed-end funds outperformed in 22 of the categories, or 88% of them, by an average annualized total return of 3.45%. Likewise, over 10 years, 80% of the closed-end fund sectors outperformed, but by an average annualized total return of just 0.44%, which is understandable given the 2007-08 financial crisis that affected many closed-end funds more because of their heavier use of leverage.

Notably for both the five- and 10-year periods, in four of eight instances where a closed-end fund category underperformed the open-end fund category, the difference was less than 1.7% and more than 4% in just three cases. And, over the five years, 12 closed-end fund categories outperformed by an annualized total return of more than 4%, and 17 categories did so by more than 3%. For 10 years, closed-end funds still beat out the open-end funds in 13 categories by 1% or more.

During the 2007-08 financial crisis years, both closed- and open-end funds generally suffered losses, yet closed-end funds underperformed in 24 categories, by an average annualized total return of 9.4%, largely due to the impact of leverage.

Does this data prove that investors should choose closed-end funds over open-end funds? Of course not; however, the data does suggest that investors may want to give closed-end funds greater consideration for inclusion in their long-term portfolio.

Robert Kenyon is managing director for business development at Virtus Investment Partners.


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