The closed-end investment industry consists of investment offices primarily engaged in issuing closed-end funds, unit investment trusts, or face amount certificates. For related information on investment industries, see SIC 6722: Management Investment Offices, Open-End and SIC 6282: Investment Advice.
525990 (Other Financial Vehicles)
Unit investment trust (UIT) and closed-end fund (CEF) companies sell shares in securities portfolios. These shares must be purchased when they are initially issued—or afterwards on the open market—and are not redeemable before a designated date. Face amount certificates are essentially obligations of the issuing company to pay a fixed sum at a specified maturity date, and often require periodic payments by the purchaser.
Because shares in this industry's portfolios must be held until a set date, they are not as popular as open-end, or mutual, funds, although they may generate greater earnings. With a stable pool of money, portfolio managers can take more risks in search of profits, often investing in volatile countries and emerging markets. In 1999, there were 85 CEFs specializing in regions of specific countries. Many closed-end funds, which are traded on stock exchanges, are bargains, since they sell for less than the value of the stocks or other investments that they hold. Funds may also sell for more than their value. UITs do better than CEFs in garnering new assets. In 1998, UITs added 60 percent in assets and held $94.6 billion. On the other hand, CEF assets increased 1 percent to $151.6 billion. Fund managers included major brokerage houses as well as investment companies.
CEFs. Closed-end fund companies are similar to open-end mutual companies in that they both sell shares in a portfolio of actively-managed securities. Shareholders benefit from efficient access to professional investment management and from portfolio diversification that they likely would be unable to achieve on their own. Unlike open-end funds, however, CEFs issue a fixed number of shares, which are sold through initial public offerings (IPOs). The money collected through this initial offering is invested in securities. After the IPO, shares may not be redeemed until a predetermined date. They must be sold and purchased through a broker on an exchange or through over-the-counter markets.
An important characteristic of a CEF share is that its price is determined by market demand and supply, rather than by the net asset value of the securities represented by the share. CEFs usually trade at a discount to their net asset value, which can vary widely for several reasons. While most CEF shares are traded on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), and the National Association of Securities Dealers Automated Quotation (NASDAQ) systems trade CEFs as well.
After an investment company initiates a CEF, it employs a fund adviser to manage the investment of the shareholders' assets, to conduct research, and to handle administrative tasks. The fund advisory firm is often a subsidiary of the investment company. In fact, the CEF is often established for the purpose of allowing the investment company's directors to earn fees from managing the fund. The adviser's management fee is usually based on the amount of assets in the fund and is commonly set on a sliding scale that declines as total assets increase. Fees of 0.3 to 1.0 percent of fund assets are common, although some funds offer incentives that are linked to performance. When combined with other fund management costs, operating expenses can consume 10 percent or more of a fund's total income.
Several types of CEFs are offered by investment companies, including equity, bond, and specialty funds. Some portfolios are highly diversified while others emphasize a particular industry or security type. In the early 1990s, about 70 percent of all CEF assets were invested in bond funds. That percentage decreased slightly, to 66 percent, by the end of 1997, when $97.9 billion of the total $149 billion invested in closed-end funds was invested in bond funds. While the primary objective of a CEF that emphasizes bonds is to produce high yields, stock fund advisers seek capital gains. Specialty funds include non diversified CEFs that focus on precious metals, venture capital, utilities, single or multiple countries, single industries, or other investments.
UITs. Like CEF companies, UIT investment firms issue shares in a fixed portfolio of assets that cannot be redeemed until a specified date, which is usually between 20 and 30 years after issuance. The shares are traded in the open market until their redemption. Unlike CEFs, however, UITs represent an undivided interest in a unit of specific securities—usually bonds. The trust does not have a board of directors and the pool of assets is fixed. The portfolio is, therefore, left mostly unmanaged for the trust's duration. The trust distributes the bonds' interest to shareholders until all the bonds mature or are called. UITs are often called defined or focused portfolios.
Because most UIT assets are invested in bonds, UIT participants purchase shares with the expectation of earning a steady, monthly income and then receiving most of their principal back when the shares expire. Investors theoretically get the benefit of holding bonds until maturation without the volatility and risks inherent in short-term trading. Unlike CEFs, or mutual funds for that matter, UIT shareholders know exactly what they are buying. One drawback, however, is that UIT portfolios are unresponsive to changing market conditions. In addition, many UIT holders find that their shares are difficult to liquidate in the open market.
In Belgium, 1822, the first closed-end fund was created by King William I. In the 1860s, similar investment trusts were formed in Great Britain. In fact, the Foreign and Colonial Investment Trust, formed in London in 1868, was still operating in the early 1990s. In the 1880s, British CEFs began investing in the United States to achieve higher returns and diversification. These funds were instrumental in providing capital to finance Civil War reconstruction and to build railroads.
British CEFs led to the development, in 1893, of the Boston Personal Property Trust, the first American CEF. Excess capital generated during the 1920s caused a boom in CEFs, or investment trusts as they were referred to at that time. Several hundred new funds were formed, including the oldest CEF still in existence today—General American Investors, founded in 1927. Some 265 new funds were established in 1929 alone, many of which invested in stocks, and were highly leveraged.
When the stock market crash of October 1929 rocked financial markets, CEF investors took a beating. One dollar invested in a leveraged CEF index fund fell to a value of about five cents overnight. A positive outcome of the Great Depression for CEFs, however, was critical legislation that served to shape and promote the industry throughout much of the 1900s. The Securities Exchange Act of 1934 and the Investment Company Act of 1940 became the basis for regulation of both open-and closedend funds.
Although asset growth in CEFs waned during the 1940s and 1950s, investors began to steadily reinvest during the 1960s and 1970s. Furthermore, the industry began to diversify its offerings. The Japan Fund, for example, became the first American CEF investing in a foreign country in 1962. Convertible funds and corporate bond funds also originated in the 1960s and early 1970s. By 1960, CEFs held about $2 billion — compared to only $613 million in 1940. However, by 1970, the industry had expanded its holdings to more than $4 billion. Total assets doubled again during the 1970s, reaching more than $8 billion by 1980.
Even though they were not introduced to U.S. markets until 1961, UITs enjoyed a growth pattern similar to that experienced by CEF companies during the 1960s and 1970s. The first UIT was a municipal securities fund. The industry expanded to include corporate and debt funds in 1972, and government securities funds in 1978. As investors increasingly sought the benefits touted by the UIT industry, assets poured into funds.
The 1980s. The boom in most financial markets during the 1980s contributed to growth for the closed-end investment industry. At the same time that securities and financial markets were benefiting from increased investment capital, investors were shifting their assets from government regulated bank deposits in an effort to garner higher returns. Often, these assets ended up in closed-end instruments or face-amount certificates.
Also contributing to the growth of the industry was a variety of new fund offerings that lured new investors. For instance, "personality funds," developed in the mid 1980s, maintained CEF portfolios that reflected the distinctive investment style of the portfolio manager. Gabelli Equity Trust, the Zweig Fund, and Z-Seven (Barry Ziskin's funds) were all popular personality funds in the 1980s and were still in existence in the late 1990s.
Single-country funds also proliferated in the 1980s. Funds that specialized in investing in Mexico, Korea, Australia, Indonesia, Germany, Turkey, and other countries experienced solid asset growth. The number of convertible bond funds also increased. UITs expanded into new financial vehicles as well, investing in junk bonds, zero-coupon bonds, and real estate.
Industry growth was evidenced by the number of public offerings for new CEFs in the late 1980s. Many of these IPOs were made following the stock market crash of 1987, when weak securities markets pushed many investors into bond funds. Although in 1980 there were no IPOs, and the following year there was only one, there were 26 in 1986, as well as 35 and 62 new issues in 1987 and 1988, respectively. Furthermore, total assets held in CEFs soared from less than $8 billion in 1985 to more than $55 billion by 1990. The number of CEFs grew from just 54 in 1985 to 209 by the end of the decade. UITs grew at a similar pace, encompassing about $130 billion in assets by 1989.
To the Mid 1990s. Many closed-end investment offices experienced steady asset growth in the early 1990s. The amount of money invested in CEFs, for instance, increased nearly 25 percent between 1991 and 1992. Weakened equity markets in the late 1980s, as well as an influx of assets from other financial institutions and investment instruments, were partly responsible for overall industry growth. Despite the success of CEFs and UITs, many investment professionals cautioned against them due to their difficulty to liquidate, lackluster returns, and the high risk involved. However, by the mid 1990s, 18 of the 150 CEFs available had returns on investment of 100 percent or greater.
Although open-end investment offices eclipsed the popularity of closed-end investment instruments, a significant portion of U.S. assets were held by UITs and CEFs in the mid 1990s. For instance, more than $85 billion was invested in CEFs, and about $200 billion in UITs had been sold. The 268 establishments in the United States selling UITs and CEFs were drawing in $388.3 million in revenue and employing 1,104 workers.
But the industry experienced a slowdown in asset growth during the same period. The saturation of CEF and UIT markets, stronger securities markets that were pushing investments into equity instruments, and the growing popularity of open-end mutual funds all contributed to the slowdown. For instance, UIT deposits fell in January 1993 to $819 million, down 12 percent from January 1992. Furthermore, while CEF assets climbed a healthy 35 percent between 1990 and 1992, this was well below the 70 percent growth experienced between 1987 and 1989.
The growing popularity of open-end mutual funds was seen as a threat to many closed-end investments. Many analysts felt that open-end funds, particularly no-loads, offered better returns. In addition, investors' open-end funds benefited from greater liquidity and more active portfolio management than with UITs. Indeed, assets in open-end funds had grown about 92 percent between 1980 and 1993, to more than $1.7 trillion—compared to the approximately $285 billion held by UITs and CEFs combined.
In the mid 1990s, the largest company in the industry was Meditrust SBI, of Massachusetts. This company had assets of $820 million and employed fewer than 100 people. The second largest company was RYMAC Mortgage Investment Corp. based in Maryland. RYMAC had assets of $564 million in 1992. Likewise, Source Capital Inc., the third largest based on its assets, had no employees and maintained capital of $286 million. The top 10 companies in the industry, in fact, employed fewer than 200 people in 1992.
In the late 1990s, the industry was seeing only modest growth in new assets deposited. Closed-end fund assets increased 5 percent between 1996 and 1997, from $142.3 billion to $150.1 billion, but only 1 percent in 1998, to $151.6 billion. Assets were held by 476 U.S. funds. In 1999, 532 closed-end funds traded on U.S. stock exchanges held $123 billion in assets.
According to the Investment Company Institute, 2.3 percent of all U.S. households owned CEFs in 1998; 80 percent of them also owned open-end funds. The typical investor had $12,000 in two closed-end funds. Domestic equity and high-yield bond funds were the most popular types. In 1998, for the first time since 1994, investments in foreign securities declined to 18 percent of all CEF assets from 21 percent the previous year.
The value of unit investment trusts fared somewhat better than CEFs, increasing 10 percent per year in the late 1990s. Outstanding UITs had a market value of $78 billion in 1996, $86 billion in 1997, and $94.6 billion in 1998. Between 1997 and 1998, UITs added 60 percent in assets, while mutual fund assets dropped 12 percent. In the late 1990s, some UIT companies were extending their product lines by joining with insurance companies to offer defined portfolios with the advantages of tax-free annuities. For example, in 1999, Nike Securities and Ohio National Life Insurance Company began offering Nike's Dow 10 UIT as part of Ohio National's ONcore Series of variable annuities.
Familiar names in the financial services industry offer UITs and CEFs. Among those firms are Morgan Stanley, Paine Webber, Prudential Securities, Smith Barney, and Van Kampen. In addition, numerous investment companies offer the products. Tri-Continental Corporation, with more than $4 billion in assets, is the largest publicly traded, diversified closed-end investment company in the United States. Petroleum and Resources Corporation has approximately $475 million invested in some 80 stocks in the only closed-end fund specializing in oil and gas and other natural resource stocks. Adams Express Company, with $1.69 billion in total assets, and General American Investors Company, with $1.02 billion in total assets, also are major closed-end fund companies. The John Nuveen Company, which sells UITs as well as other investments, had 1999 sales of $349 billion.
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Investment Company Institute. "U.S. Household Ownership of Closed-End Funds in 1998." Fundamentals: Investment Company Institute Research in Brief. 8, no. 3 (April 1999). Available from http://www.ici.org .
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