Closed-End Funds

What are the differences between “closed-end funds” and “open-end funds”?

Closed-end funds differ from open-end funds in some very important ways.

First, let’s identify the similarities. In general terms, both types are built around professionally managed portfolios intended to meet a specific investment objective. At any point in time, the value of the portfolio can be determined, and, adjusting for any liabilities incurred by the fund, used to calculate the net asset value (“NAV”). The NAV per share is the intrinsic value of one share of the fund.

The key difference between a closed-end fund and an open-end fund is the manner in which the shares change hands. Closed-end funds issue a fixed number of shares at the inception of the fund (hence the term “closed”). The shares are usually listed on a major stock exchange (each of Flaherty & Crumrine funds is listed on the NYSE) and the price of the shares will fluctuate based on what a willing buyer would pay for the shares of a willing seller(just like buying or selling shares of Microsoft or any other listed company). The price may or may not bear a close relationship to the NAV. If the market price is above the NAV, the Fund is said to be trading at a “premium”. If the market price is below the NAV, the Fund is said to be trading at a “discount”.

Open-end funds issue new shares and redeem old shares daily (hence the term “open”). During business hours, investors may indicate to the fund their desire to purchase or sell shares in the fund. The fund will compute the NAV as of the close of business and either issue new shares or redeem outstanding shares at that NAV.

There are other important differences (for example, it is more common for closed-end funds to employ leverage), but the key difference is the mechanism for trading the shares of each.

Why can a closed-end fund trade at a premium or discount to NAV?

Unlike open-end funds which issue and redeem shares directly with their shareholders at a price equal to the underlying value of all fund assets (Net Asset Value or NAV), closed-end fund shareholders do not have the right to redeem their shares. Instead, closed-end fund shareholders buy and sell their shares on markets like the New York Stock Exchange. A closed-end fund’s shares should trade relative to the NAV of the fund — the market, however, further exposes the price of the shares to the laws of supply and demand and the price can and does vary widely from NAV.

Supply and demand for a fund is dictated by each investor’s perception of the underlying value of the shares relative to other available investment options.

The starting point for any investor considering selling or purchasing shares of a fund is the NAV calculated by the fund. With income funds, like the Flaherty & Crumrine funds, investors also consider distribution levels. These two performance components of NAV and income are reflected in the fund’s total investment return on NAV. In fact, the best measure of the performance of an investment adviser is the fund’s total return based on NAV.

Like all investors, investors in closed-end funds make their own decisions about the fundamental quality of a fund’s NAV and the likelihood that it will continue to produce similar total returns on NAV. An investor may value a fund’s shares at a premium to NAV if the investor believes that the fund is likely to perform better than it has in the past, because of projected dividend levels, net asset value, net asset value volatility, call protection, quality of fund management and portfolio credit quality. Alternatively, an investor may similarly value a fund’s shares at a discount to NAV based on negative interpretations of the same factors.

Investor decisions are never made in isolation, however, and supply and demand cannot be fully understood without reference to the market conditions for a fund’s shares and the investor’s objectives and alternative investment opportunities. In other words, an investor may decide to purchase or sell shares of a fund based on reasons unrelated to his or her assessment of the fund’s total return on NAV. Commentators speculate that some investors apply an automatic discount to NAV because of the nature of the closed-end fund structure itself — yet some funds consistently trade at premiums. Once an investor has decided to purchase shares of a closed-end fund (perhaps because of some of their inherent advantages), comparative performance matters as well. Stated another way, a fixed-income investor will typically gravitate to that fund in a group of funds with similar investment objectives which offers the best yield for the amount of risk involved.

Finally, investment decisions may be motivated for reasons beyond the performance of the fund, the closed-end structure, or comparative performance. Investors always have personal economic situations that impact their decisions. One example of this may be year-end tax selling. If an investor has losses in a closed-end fund, and gains in some other investment, that investor may make a rational decision to sell his or her shares of the fund at year-end in order to offset any tax gains. In a market environment, tax selling is especially detrimental because it can provide increased supply which may drive down the market price which can in turn lead to more tax selling.

Of course, no single reason can explain the price determined by a market. There are as many reasons, or combination of reasons, as there are shareholders for why each investor sells or buys shares. And, in the end, the collective effect of all these investor decisions may result in market prices at a premium or discount to NAV.

The Flaherty & Crumrine funds are no different than other closed-end funds, and their market price will be controlled by the laws of supply and demand.

How does leverage impact the amount of common stock distribution?

Each Flaherty & Crumrine fund uses leverage to enhance returns to common shareholders. The fund may be able to borrow money at rates well below rates it can earn on the investment portfolio. Of course, the benefit of leverage is greatest when the “spread” between income generated by the portfolio and cost of leverage is wide. However, the converse is also true; leverage doesn’t provide as much income when the spread is narrow and may increase volatility of the common shares.

How does a fund report the breakdown between dividends and interest?

Each fund will calculate the breakdown between Qualified Dividend Income (QDI) and interest and report it to shareholders on Form 1099 after each calendar-year end. We will also publish the breakdown on the Fund’s website and in the Annual Report to Shareholders.

How can investors purchase shares?

Each Flaherty & Crumrine fund’s shares trade on the New York Stock Exchange (NYSE). As with any other companies listed on the NYSE, investors can purchase or sell shares during normal business hours of the NYSE through a registered broker-dealer.

Can I reinvest distributions directly into a fund and is there any benefit over purchasing shares in the open market?

The answer to both questions is yes. Each fund’s Dividend Reinvestment Plan (the “DRIP”) provides a means of acquiring additional shares of the Fund without paying the full market premium, if any. When the market price is above NAV, new shares will be issued to participants in the Plan at the higher of NAV or 95% of the then current market price. Participating shareholders can therefore receive a discount on their reinvested shares of up to 5% of the market price. If the market price of the shares is below the NAV, the Plan purchases shares in the open market. The brokerage commission charged for acquiring these shares is competitive with most “discount” brokers. Shareholders should be aware that not all broker-dealers participate in the Fund’s dividend reinvestment plan. If your shares are held in a brokerage account, ask your broker if his/her firm is set up to participate. If you hold your shares in certificate form, or if you would just like more information, call BNY Mellon Investment Servicing (US) Inc., at 1-866-351-7446.

What does “Ex-Div” refer to?

Every month the funds pay distributions, and the value of the dividend is subtracted from the funds’ NAVs on the Ex-Dividend date each month. So when the NAVs are reported with an “Ex-Div” behind them, it means that the amount of the dividend has been taken out of the Net Asset Value.