6.4 Closed-End Funds & UITs

These pooled investment vehicles have characteristics distinct from open-end mutual funds. Understanding their unique features is essential for the Series 65 exam.

Closed-End Funds

Structure

Closed-end funds (CEFs) issue a fixed number of shares through an initial public offering (IPO), then trade on exchanges like stocks.

Share Issuance: Closed-End Funds - Fixed (from IPO); Open-End (Mutual) Funds - Unlimited

Trading: Closed-End Funds - On exchanges; Open-End (Mutual) Funds - With fund company

Pricing: Closed-End Funds - Market price; Open-End (Mutual) Funds - NAV

Redemption: Closed-End Funds - Sell on exchange; Open-End (Mutual) Funds - Redeem at NAV

Premium/Discount: Closed-End Funds - Common; Open-End (Mutual) Funds - Never

Leverage: Closed-End Funds - Commonly used; Open-End (Mutual) Funds - Limited

Key Characteristic: No Continuous Creation/Redemption

Unlike mutual funds:

- CEFs do not continuously issue new shares when investors want to buy

- CEFs do not redeem shares when investors want to sell

- Investors must buy from and sell to other investors on the exchange

Premiums and Discounts

Since closed-end funds trade on exchanges, their market price can differ from their NAV.

Definitions

Premium: Market price greater than NAV. Formula: (Price - NAV) / NAV x 100

Discount: Market price less than NAV. Formula: (Price - NAV) / NAV x 100

Example

A CEF has:

- NAV: $20.00 per share

- Market price: $18.00 per share

- Discount: ($18 - $20) / $20 = -10%

The fund trades at a 10% discount to NAV.

Why Do Discounts/Premiums Occur?

Management quality perception: Premium if highly regarded

Expense ratio: Discount if expenses are high

Distribution yield: Premium if yield is attractive

Leverage strategy: Varies based on effectiveness

Market sentiment: Can push to extremes

Illiquidity of holdings: Discount if hard to value

In Practice

Many CEFs persistently trade at discounts, which can create opportunities:

- Buy at discount = buy $1 of assets for less than $1

- But discounts can widen, causing losses

- Activist investors sometimes pressure funds to convert to open-end (eliminating discount)

Closed-End Fund Features

Use of Leverage

CEFs can use substantial leverage to enhance returns:

Borrowing: Fund borrows money to buy more securities

Preferred Stock: Issues preferred shares to raise capital

Reverse Repos: Short-term borrowing arrangements

Leverage Impact:

- Magnifies gains in rising markets

- Magnifies losses in falling markets

- Interest/dividend costs reduce returns

- Increases overall risk

Common CEF Strategies

Municipal Bonds: Tax-exempt income; often leveraged

High-Yield Bonds: Enhanced income from junk bonds

Covered Calls: Income from option premiums

MLPs: Energy infrastructure

Global Income: International bonds and dividends

Unit Investment Trusts (UITs)

UITs are a unique type of investment company with a fixed, unmanaged portfolio and a set termination date.

Structure

Management: UIT - Unmanaged; fixed portfolio; Mutual Fund - Actively managed

Portfolio Changes: UIT - None (except specified events); Mutual Fund - Continuous

Termination: UIT - Set date; Mutual Fund - Perpetual

Board of Directors: UIT - None; Mutual Fund - Required

Investment Adviser: UIT - None (after creation); Mutual Fund - Required

Expenses: UIT - Lower (no management fee); Mutual Fund - Higher

How UITs Work

1. Sponsor creates trust with specific portfolio of securities

2. Units sold to investors at NAV plus sales charge

3. Portfolio held until termination (or bonds mature)

4. Income distributed to unit holders as received

5. At termination: assets sold, proceeds distributed

Types of UITs

Fixed-Income UITs

Most common type:

Holdings: Corporate or municipal bonds

Income: Interest passed through to investors

Maturity: Bonds held to maturity

Termination: When all bonds mature or are called

Return of Principal: Returned as bonds mature

Example: A 10-year municipal bond UIT buys 20 different muni bonds. As each bond matures, principal is returned to investors. When all bonds mature, the trust terminates.

Equity UITs

Holdings: Stocks selected at creation

Income: Dividends passed through

Termination: Typically 1-2 years

At Termination: Stocks sold, proceeds distributed

Common equity UIT strategies:

- Dogs of the Dow (highest-yielding DJIA stocks)

- Sector-focused portfolios

- Dividend-growth stocks

UIT Pricing and Redemption

Pricing

Public Offering Price = NAV + Sales Charge (typically 1-5%)

Redemption Options

Redeem with Sponsor: Receive NAV (may be below purchase price)

Secondary Market: Sell to other investors

Hold to Termination: Receive final distribution

On the Exam

Key UIT characteristics to remember:

- Fixed portfolio: No active management

- Set termination: Not perpetual like mutual funds

- Self-liquidating: Trust dissolves at termination

- Lower costs: No ongoing management fees

- No board of directors: Unlike mutual funds

Comparison: CEFs vs. UITs vs. Mutual Funds

Management: Closed-End Funds - Active; UITs - None (unmanaged); Open-End Mutual Funds - Active or passive

Shares: Closed-End Funds - Fixed; UITs - Fixed; Open-End Mutual Funds - Unlimited

Trading: Closed-End Funds - Exchange; UITs - Sponsor/secondary; Open-End Mutual Funds - Fund company

Pricing: Closed-End Funds - Market price; UITs - NAV + charge; Open-End Mutual Funds - NAV

Premium/Discount: Closed-End Funds - Yes; UITs - No; Open-End Mutual Funds - No

Termination: Closed-End Funds - Perpetual; UITs - Set date; Open-End Mutual Funds - Perpetual

Leverage: Closed-End Funds - Common; UITs - Rare; Open-End Mutual Funds - Limited

Expenses: Closed-End Funds - Moderate; UITs - Low; Open-End Mutual Funds - Varies

Key Takeaways

- Closed-end funds have a fixed number of shares and trade at market prices that may be above (premium) or below (discount) NAV

- CEFs commonly use leverage to enhance returns, increasing both potential gains and losses

- UITs have fixed, unmanaged portfolios that terminate on a set date

- UITs are self-liquidating: assets are sold and proceeds distributed at termination

- UITs have no board of directors or investment adviser after creation

- Both CEFs and UITs are registered under the Investment Company Act of 1940