With Their Prom-ise of regular income and potential for capital gains, closed-end funds have sold like hotcakes during the past few years, and issuers have been loading the market with new products to satiate investor appetites.

The market value of closed-end funds in Canada was $34 billion at mid-2006, with the number of funds issued and outstanding totalling 268 and the number of issuing participants numbering 62, according to Toronto-based Investor Economics Inc. In comparison, only three years ago the market size was $16 billion, the number of instruments was 142 and the number of managers was 43.

“There are a lot more closed-end funds around in Canada these days, and much of the growth has been in products with a diversified portfolio of securities designed to produce an income,” says Dan Hallett, fund analyst and president of Windsor, Ont.-based Dan Hallett & Associates Inc
Although the income-producing versions are the most popular, closed-end funds come in many varieties representing specific asset classes or geographic regions. The funds can have different investment objectives, strategies and portfolios, and are therefore subject to different risks, volatility, fees and expenses. Some funds hold diversified baskets of income trusts or preferred shares and pay out a regular income, while others are designed to offer capital gains. Others employ more aggressive strategies than allowed for regular mutual funds, such as short-selling, options trading and the use of leverage.

However, advisors need to make sure their clients understand that closed-end funds don’t work quite the same as regular mutual funds.

“This is an embryonic market category that is going through some teething pains,” says Steve Mantel, president of Toronto-based First Trust Portfolios Canada, manager of the First Trust Highland closed-end funds. “It’s had explosive growth, and people are just getting used to how it works. Closed-end funds are terrific products if they’re understood properly and bought for the right reasons.”

Unlike regular mutual funds, closed-end investment funds are not bought and sold at their net asset value on a daily basis by the sponsoring investment manager (although some have a feature whereby they will redeem units at NAV for a specified period of time every year). Instead, there are a fixed number of units issued, and they trade on a stock exchange like shares.

Although the investment activities of a closed-end fund will affect its NAV, the market value at which units are bought and sold on the exchange will also be affected by investor demand. It’s important that advisors ensure their clients understand that their units could trade at either a discount or premium to the fund’s NAV, says Mantel. The market price can be determined any time the securities exchanges are open, and will be affected by changing market conditions and sentiment.

The premium or discount phenome-non can actually create opportunities for investors to profit by buying fund units when there is potential for the discount to narrow or disappear or for a premium to increase. A discounted price may also result in a healthier yield than the units had at their issue price.

“Regular mutual funds can always be bought and sold at net asset value, but the price of closed-end funds is affected by supply and demand,” says Mark Chow, senior analyst at Morningstar Canada. “Closed-end funds may trade at a premium or a discount, but because arbitrageurs out there can assess the underlying value of a portfolio, the market price doesn’t usually get too far out of whack.”

Chow says that although investors may hope to make money on a move in the unit price from a discount to a premium, unless the price increase is large, the sales commissions paid by clients on the trade can eat up any profit on the price movement. And if there are problems with liquidity, as there sometimes are with some of the lesser-known closed-end trusts, price discounts can be driven to even deeper levels, says Barnaby Ross, vice president at RBC Dominion Securities Inc.

“The public has bought gobs of these products, but there are not a lot of brokers and analysts following them once they become listed, and they can become illiquid,” Ross says. “If there is no bid and no liquidity, clients can be frustrated by a growing discount. There’s precious little research on these products, and some funds might become orphans.”

@page_break@Ross says it’s even more important with closed-end funds that advisors do a lot of up-front research on the track record of the managers behind the fund and the type of exposure the client is getting. With certain funds offering a yearly NAV redemption window, the market has been affected by sophisticated arbitrageurs who buy up units trading at a discount, then later redeem them from the manager at NAV.

In some cases, this has significantly reduced the size of the fund’s asset pool and further depressed the market price of the remaining units. If the annual NAV redemption period becomes open to abuse, the rules may have to evolve to make the product more palatable to investors, says Mantle.

Because closed-end funds issue a fixed number of shares that are then bought and sold on the open market, investor trading activity need have no impact on the fund manager’s strategy, unless there are a huge number of redemptions during the annual redemption period. The manager can take charge of the assets, knowing that he or she is dealing with a fixed pool of capital.

Conversely, open-end funds are subject to inflows and outflows of capital as fickle investors purchase and redeem, and these flows can impact investment decisions.

The closed-end fund manager does not have to be concerned with selling assets to meet redemptions or with investing cash that may pour in during hot markets when securities have become expensive.

The manager can also take a long-term view to achieve results, and doesn’t have to worry about impatient investors bailing out if a strategy takes time to bear fruit or if they simply want to sit on the sidelines for a while.

Fees and costs are another important consideration when making a decision on whether to buy a closed-end or an open-end investment fund for a client. Hallett says the various fees and trading costs need to be examined closely, and there is sometimes a trailer fee built into the costs of closed-end funds on the initial public offering. Once the units of closed-end funds are trading on an exchange, investors will be paying a brokerage commission on both the buy and sell sides of the trade, in the same way as they would with a regular stock.

On the other hand, open-end funds can be bought with either front-end or rear-end load options, and investors can avoid the sales commission altogether in some cases. However, the annual management expense ratios of closed-end funds are often between 50 basis points and a percentage point lower than comparable open-end mutual funds.

“An open-end fund requires a lot more disclosure and a lot more paper. And all of that gets charged back to the fund, which pushes up the MERs,” says Brendan Caldwell, president of Caldwell Investment Management Ltd. “Closed-end funds can be more flexible in terms of how they communicate with investors, and they don’t have as much fixed overhead.”

Although there is a wide variety of issuers, mutual fund managers that have added closed-end funds to their product line include Caldwell In-vestment Management, Dy-namic Funds Ltd., Guardian Capital LP, Middlefield Group, Sentry Select Capital Corp., Acuity Investment Man-agement Inc., Sceptre Investment Counsel Ltd. and Front Street Capital Corp.

One fund company that has been particularly active is Burlington-based AIC Ltd. Along with a group of individual co-founders, it launched opernican Capital Corp late last year, and since then Copernican has been busy launching a series of closed-end funds to add to the four that were hatched by AIC during the past two years. The latest offering is Copernican World Financial Infrastructure Trust; its units are expected to be listed on the Toronto Stock Exchange by mid-September. The units will pay an annual yield of 5%, based on the issue price of $10. Income will be derived from capital gains and dividends on a global portfolio of securities tied to wealth-management businesses, including money-management firms, investment dealers, securities exchanges, insurance brokers custodians and information-processing firms.

“Financial institutions that collect on the money that flows through them are essentially toll roads,” says John Miller, senior vice president of sales and marketing for AIC, and executive vice president at the Copernican affiliate.

“There are bank service fees, for example,” he says, “or commissions on the products sold by insurance and brokerage firms. On a global business, there are opportunities for great dividend yields on securities tied to these businesses.”

Another type of closed-end fund is represented by Urbana Corp. , managed by Caldwell Investment Management. Urbana began as a mining company set up in the 1940s, but later became a trading and investment vehicle to buy and sell stocks. A couple of years ago, Urbana completed a secondary financing and made a highly profitable investment by buying seats on the New York Stock Exchange. Although some of the product alternatives are officially listed as closed-end investment funds, others such as Urbana may be publicly traded corporations that have built up a large investment portfolio.

“One of the great advantages of a closed-end structure is that you can operate outside the restrictions that apply to regular open-end mutual funds,” Caldwell says. “With a regular fund, you simply couldn’t have 90% of your assets invested in seats on the New York Stock Exchange. The key is to keep your shareholders in the loop as to what you’re doing and why.”

Even U.S.-based Berkshire Hathaway Inc. is considered by some to be a virtual closed-end investment fund run by the legendary Warren Buffett, who oversees its portfolio of stocks and interests in private businesses.

Conversely, Dynamic Precious Metals Inc. began as a closed-end investment fund holding a portfolio of various gold shares, but it evolved in the other direction and became a full-fledged mining company. IE