An open and closed case

Not as well known as their open-end counterparts, closed-end trusts can be excellent bets for income 
and growth.

Most investors are familiar with the traditional mutual funds offered by financial advisors. Commonly known as open-end trusts, mutual funds provide investors with professional management, diversification, liquidity, and hopefully financial returns in the form of dividends, interest, and capital gains.

The term “open end” refers to the practice of issuing for sale or cancellation units in the fund priced each day at the net asset value of the underlying fund. For example, if XYZ fund had
a market value of $10 million and had issued
an outstanding two million units, then the net asset value would be $5 per unit. Any new purchases would increase the size of the
fund being managed, and sales would
decrease total assets.

Closed-end trusts look very much like their open-end cousins in terms of providing unit holders with professional management, diversification, and financial returns, but in practice the units trade on stock exchanges and are priced according to the laws of supply and demand. This means that individual closed-end trusts can trade at significant discounts or premiums to the net asset value of the fund depending on the supply of buyers or sellers on any given day.

{advertisement} This difference can provide savvy investors with buying opportunities during extreme market swings, giving them extra market returns. For example, if QRS Closed End Trust has a past history of consistently trading at a two per cent discount to its daily net asset value, and suddenly a large order to sell a block of units hits the market, driving it to a 15 per cent discount to its net asset value, then a tactic of putting in low-ball bids can provide extra returns once the supply and demand has stabilized.

Closed-end trusts are not a new investment vehicle. Former Prime Minister Arthur Meighen formed Third Canadian General Investment Trust in 1928 with the purpose of providing investors with a diversified portfolio of Canadian and international stocks, bonds, and other investments. However, it did not trade on the Toronto Stock Exchange until 1962, which means prior to that year investors would be able to buy units only in an over-the-counter market or from Third Canadian General. Today, almost all Canadian closed-end trusts trade on a recognized stock exchange.

Some investors prefer the features and benefits of closed-end trusts to the larger and more popular open-end trusts. Investors in closed-end trusts don’t have to worry about untimely redemptions, so they can keep the trusts fully invested and will benefit from longer-term time horizons in their investment portfolios. In addition, some closed-end trusts can employ the use of leverage by issuing preferred shares or debt instruments to increase potential returns of the trust. These strategies are generally not available to open-end trusts, and during market downturns open-end trusts sometimes have to sell valuable holdings to create liquidity for mutual fund redemptions.

In the past few years, we have seen one additional strategy employed by specialty closed-end trusts, namely, the use of options within the portfolio to boost investment returns. Mulvihill Capital Management and Faircourt Asset Management use stock option strategies to enhance returns and boost income on otherwise static portfolios on a number of closed-end trusts. For example, both companies have closed-end trusts that invest in gold mining companies and use option strategies to provide investors with monthly income. Since most mining companies don’t pay dividends, the gold trusts can be a better alternative to owning individual mining stocks or gold bullion.

Investors must use caution when selecting closed-end trusts. In early 2007, Middlefield Group Ltd. closed an initial public offering of units in the Uranium Focused Energy Fund. The objectives of the fund (as described in the prospectus) were to achieve capital appreciation of the fund’s investment portfolio over the life of the fund and to pay quarterly distributions to holders of the units. The fund did not have a fixed distribution policy but management believed they could achieve a five per cent annualized return based on a $10 IPO price. Just over a year later, the fund managers made the decision to suspend distributions. Investors who had purchased the units with an expectation of capital appreciation and income were sorely disappointed.

Open- and closed-end trusts are in the business of making money. They provide a portfolio management fee for service based on the size of the assets under administration.  With an open-end trust, each new purchase increases the size of the funds under management, which in turn increases the size of the fee. Closed-end funds charge a fee to manage the investment portfolios, but since they do not issue new shares with each transaction, their fee is limited to the growth of the underlying fund. To get around that obstacle, some management companies periodically issue warrants to buy additional shares at or near the net asset value. The newly issued shares increase the assets under administration and by extension the management fee collected. Others create new trusts with exciting new strategies or specialty mandates and titillating promises of higher returns.

This was particularly evident during the 1990s and 2000s, when management companies advertised the benefits of newly created trusts designed specifically to own a diversified basket of income trusts and capture the high income distributions from the fastest-growing segment of corporate Canada. For many investors, closed-end trusts turned into a financial nightmare when the federal government changed the tax laws on income trusts. Closed-end trusts saw the net asset values of their funds plummet, and spooked investors liquidated their investments — many of them at significant discounts to their net asset values.

Closed-end trusts provide investors with significant opportunities in selected sectors of the marketplace, but like their open-end counterparts, due diligence is required when making a selection. Most firms publish the net asset value of their funds, so tracking the price of the fund relative to its net asset value can provide buying and selling opportunities. Investors need to know and understand the objectives of the fund, and, more importantly, know the track record of the fund managers. Always bet on the jockey and not the horse. Two of the best sources are and

Steve Bokor, CFA, is a licensed portfolio manager with PI Financial Corp Inc., a member of CIPF.