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Closed-End Funds Raise Awareness

NEW YORK-In the flurry of newly issued exchange-traded, lifecycle and lifestyle funds that have dominated investors' attention in recent years, one product has failed to capture the attention some say it deserves: the closed-end mutual fund.

Older than their more popular open-ended counterparts, closed-end funds are also less understood, according to John P. Calamos, chief executive and chief investment officer of Calamos Investments in Naperville, Ill.

"There's a lack of investor knowledge," Calamos said, preceding a workshop on closed-end funds hosted by the Investment Company Institute (ICI) held here. Calamos Investments launched its first closed-end fund in 2002 and now manages four.

Such ignorance makes closed-end funds tough products to sell, especially in the secondary market. In fact, according to ICI statistics, about 3.3 million, or about 3.1%, of all households own closed-end mutual funds, compared to 47.5% of households owning any mutual fund. Furthermore, those who own closed-end funds tend to be savvier investors; 81% also own open-ended funds. "The bottom line for us is: how do we educate the public more?" Calamos said.

The average closed-end fund owner is about 48 and more affluent than the average mutual fund holder. For example, the average household income of a closed-end fund shareholder is $75,000 per year, compared to $45,000 overall, and they have an average of $300,000 in assets, compared to $75,000 for all U.S. households.

Closed-end funds should have much broader appeal due to their distributions, Calamos said. Some funds pay monthly, he noted. "It's an alternative to fixed income as an income vehicle," he said. Again, the challenge is communicating that value to current and potential investors, he noted.

Part of the reason closed-end funds are so inscrutable to the average investor, is their structure. Unlike open-ended funds, closed-end funds only issue a certain number of shares. Once all of the shares issued at the initial public offering are sold, the only way to buy in, or sell out, is on the open market. That means that managers are not subject to adjusting to accommodate inflows or redemptions.

Such stability allows managers to stick strictly to their core investment strategies, without having to adjust to accommodate transfers in or out, said Charles M. Royce, president and chief investment officer of the Royce Funds in New York. It also allows closed-end fund managers to tap into asset classes open-ended funds may not, Calamos added.

But the same stability that allows fund managers greater discipline, can also affect the amount that investors who want to sell their shares can command on the open market. Sometimes, that price can be higher than the net asset value per share, or, more typically, it can be lower, a concept that most experts say has never been satisfactorily explained, and one that is hard for investors to accept-especially those accustomed to the transparency of open-ended funds and ETFs, said Dan Culloton, a fund analyst with Morningstar in Chicago. One theory about discounts is that they are caused by little more than marketplace perceptions of a fund, its manager or the asset class overall.

Calamos said this very discount could be used by a savvy manager as a selling point. "A fund temporarily trading at a discount can be a bargain," he said. And investors could be educated that even if they can't sell a share for as much as they bought it, over time, the distribution payments might more than make up the difference, he added.

Over time, as more and more investors better understand how closed-end funds work, the effect of market perception on the price spread may shrink, lowering both premiums and discounts, and bringing closed-end share prices closer to net asset value, speakers said.

"It might make people less skittish, it might increase demand, and it might lead to more opportunities to launch funds [for closed-end investment companies]," Culloton said.

But investors aren't the only people closed-end companies must better communicate with, said Michael E. Kitces, director of financial planning at Pinnacle Advisory Group in Columbia, Md.

"The challenge from the broker side is that you as the broker have to understand how it works so that you can explain it to a client," Kitces said.

After all, these funds are generally sold, not bought. With approximately 630 closed-end funds on the market, that's a lot of products to learn.

Each fund is different, and in order to understand them, brokers must pay close attention to the way they generate the money paid out in distributions. "The yield on a lot of closed-end funds is boosted by leverage," said Culloton. "They're borrowing money to juice their yields," he said. The manager recoups part of that cost, since investors pay fees based on the NAV, including the borrowed amount, thereby reducing their own profits slightly.

The bigger threat, though, is what happens when there's a market disruption, or swing in interest rates, and the manager is faced both with paying back the borrowed money and preparing for the next distribution. In those cases, funds can quickly become perceived as poor performing, perhaps driving a deeper discount on shares on the secondary market. Even worse is if managers continue to pay distributions, eroding the net asset value of the fund. "And that can be harmful to shareholders," Culloton said.

Brokers and advisers don't have much incentive to learn the intricacies of each closed-end product, when there are various wrap accounts and other tools that are easier for both the salesman and the customer to understand, Kitces said.

One way to lure brokers might be for companies to create larger closed-end funds, so that there are fewer products to learn, and to make sure both the primary and secondary sales communities understand those products well. "Then, instead of a new product, you have a new story to tell clients," Kitces said.

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