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Like a traditional mutual fund, a Closed-End ETF is an investment company that pools the assets of its investors and uses professional managers to invest the money to meet clearly identified objectives, such as current income or capital appreciation. However, unlike a mutual fund, a Closed-End ETF issues a fixed number of shares through an initial public offering, and lists those shares on a national stock exchange such as the New York Stock Exchange (NYSE) or the American Stock Exchange (AMEX). Investors who wish to buy or sell fund shares do not purchase or redeem directly from the fund - rather, they buy or sell fund shares on the stock exchange in a process identical to the purchase or sale of any other listed stock.
No. Although Closed-End ETFs have a fixed number of shares outstanding, investors can purchase and sell shares in Closed-End ETFs at any time during the trading day, similar to any other listed stock.
Like mutual funds and stocks, Closed-End ETFs may be purchased in regular brokerage accounts (individual or joint-name), retirement plan accounts, trust accounts or custodial accounts. Closed-End ETFs can be purchased and sold on national exchanges just like any other stock. All the strategies associated with stocks, such as market orders, limit orders, stop orders, short sales, and margin buying can be used in the purchase and sale of Closed-End ETFs.
No. Because Closed-End ETFs trade on national exchanges similar to stocks, there is no sales charge attributed to the transaction, although your broker will charge a commission for the stock purchase or sale.
Just like regular stocks, investors can hold Closed-End ETFs in book entry or in certificate form. If you hold the shares in book-entry, your broker maintains the records for the shares, and investors can transact in those shares without providing any paper certificates. In certificate form, a physical certificate is mailed to the investor, and any transactions associated with fund shares must be accompanied with the certificate.
Although Closed-End ETFs have a fixed number of shares and assets outstanding, there are mechanisms that fund managers can use to raise additional capital. Fund management can raise additional capital by issuing shareholders rights to buy new common shares at predetermined prices. These offerings often involve substantial discounts to net asset value to encourage participation, which also dilutes common shareholder ownership in the fund.
Typically, shareholders can choose to receive any dividends distributed by the Closed-End ETF in cash, or use the dividends to purchase additional fund shares. An automatic dividend reinvestment plan automatically invests all dividends received by investors in additional fund shares (this is the default choice in some Closed-End ETFs).
The specific securities that Closed-End ETFs hold is dependent on the portfolio manager and the investment objectives of the fund, and can range from a concentrated portfolio of just a few companies, to a diversified portfolio of several hundred companies.
All Closed-End ETFs issue common shares. Many funds also attempt to generate a higher level of income for their common shareholders through leverage. One method to implement leverage is for a fund to issue preferred stock that is designed to pay lower short-term rates to investors seeking short-term liquidity. The proceeds are used to buy generally longer-term investments. Common shareholders can earn extra income from the difference between the rates earned on the fund's long-term bond portfolio and the short-term rates paid to preferred shareholders.
Because of leverage, the net asset value per common share will be more volatile than those of comparable unleveraged funds, since the increases or decreases in the total portfolio value are all attributed to the common shares.
Because Closed-End ETFs are set up as investment companies, they are prohibited from engaging in any activity that is not of an investment nature. The only real way for a Closed-End ETF to go out of business is for all the securities in its portfolio to become worthless.
Since there is no guarantee that funds trading at a discount will ever trade at their net asset value, there is no guarantee that the investor can make money by purchasing shares trading at a discount and hoping for that discount to disappear. Alternatively, there is no guarantee that funds trading at a premium will continue to trade at a premium. Investors that purchase funds trading at a premium may be subject to premium erosion, and even trading at a discount.
For specialized investments (such as specific industries or countries), wouldn't an open-end mutual fund offer greater diversification than a Closed-End ETF?
Although many mutual funds and Closed-End ETFs are managed in a similar manner during rationale markets, Closed-End ETFs may offer an advantage during periods of market stress. Because Closed-End ETFs do not have to liquidate positions as shareholders redeem shares, Closed-End ETFs are better situated to ride out this period without adversely affecting the portfolio.
Similar to traditional open-end mutual funds, Closed-End ETFs distribute their earnings to shareholders in two ways. First, income dividends from interest or stock dividends are passed through to shareholders, net of expenses. Second, realized capital gains (net of realized capital losses) distributions are passed through to shareholders (typically once a year in November or December).
However, several leveraged Closed-End ETFs also have managed distribution policies for their common shareholders. That is, the fund promises to distribute a fixed portion of their net asset value each year. A fund may institute this policy to differentiate itself from competitors and to attempt to narrow the gap between price and net asset value. However, fixed payout plans put pressure on fund managers to meet their payment obligations. During market downturns, if the fund does not have sufficient income and realized gains, it would need to pay these distributions from capital, reducing its asset base. Therefore, funds with managed distribution policies may tend to hold more cash and bonds than those without such a policy, all other things being equal.
Regular preferred securities have been around for a long time. However, taxable preferred securities are relatively new, with the vast majority of new issues debuting after 1995. As of the first quarter of 2002, there have been $180 billion of taxable preferred securities issued. Approximately two-thirds of these taxable preferred securities are exchange listed, with the remainder trading in the over-the-counter market.
Unlike the tax treatment of typical preferred securities, taxable preferred securities do not qualify for the dividends-received deduction for corporations. They are often issued by trusts established by operating companies, and are not a direct obligation of the operating company. The trust is generally treated as transparent for federal income tax purposes such that the holders of the taxable preferred securities are treated as owning beneficial interests in the underlying debt of the operating company. Accordingly, payments of these securities are treated as interest rather than dividends for federal income tax purposes, and are not eligible for the dividends received deduction. Because taxable preferred securities do not quality for the tax-favorable dividends-received reduction, they generally offer higher yields than regular preferred securities.
Retail investors are the dominant segment investing in $25 par securities, perhaps due to the generally higher yield opportunities and perceived quality of the asset class.
These securities are almost exclusively owned by the institutional market, which includes insurance companies, pension funds, corporations and some mutual funds. A portion of these securities have actually been securitized in $25 units and offered to the retail market.
Congress created REITs in 1960 to make investments in large-scale, income-producing real estate accessible to smaller investors. In the same way as shareholders benefit by owning stocks of other corporations, the stockholders of a REIT earn a pro rata share of the economic benefits that are derived from the production of income through commercial real estate ownership. REITs offer distinct advantages for investors; greater diversification through investing in a portfolio of properties rather than a single building and expert management by experienced real estate professionals.
In order for a company to qualify as a REIT, it must comply with certain provisions within the Internal Revenue Code. As required by the Tax Code, a REIT must:
Individual investors directly own REIT shares purchased on the open market. Other typical buyers of REITs are pension funds, endowment funds and foundations, insurance companies, bank trust departments and mutual funds. REIT shares typically may be purchased on the open market, with no minimum purchase required. Many investors may also own REITs through mutual funds that specialize in public real estate companies.
Investors may prefer to invest in REITs for their high levels of current income. In addition, investors looking for ways to diversify their investment portfolios beyond other common stocks as well as bonds are attracted to the unique characteristics of REITs.
REITs are not partnerships, although REITs use partnerships to engage in joint ventures. There are important organizational and operational differences between REITs and limited partnerships, especially in tax reporting.
An investor in a REIT receives a traditional IRS Form 1099 from the REIT, indicating the amount and type of income received during the year. An investor in a partnership receives a more complicated IRS Schedule K-1.
REITs are required by law to distribute each year to their shareholders at least 90 percent of their taxable income. Thus, as investments, REITs tend to be among those companies paying the highest dividends.
For REITs, dividend distributions for tax purposes are allocated as ordinary income, capital gains and return of capital, each of which may be taxed at a different rate. All public companies, including REITs, are required to provide their shareholders early in the year with information clarifying how the prior year's dividends should be allocated for tax purposes.
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