What it means
Investment law in the United States sorts investment companies into several types, and a management company is one in which a manager actively chooses the investments. It is then divided into open-end and closed-end types.
The closed-end version issues a set number of shares at the outset and stops, which is why it is called closed. Investors who want to leave sell their shares to another investor, because the company itself does not redeem them at net asset value.
Net asset value, or NAV, is what the portfolio is worth after deducting debts, divided by the number of shares. The market price can therefore sit above or below NAV, depending on demand.
The company is run by a board of directors, which hires an investment adviser and sets the objectives and policy. The adviser is paid a management fee, usually a percentage of the assets under management (the total value of what is being looked after).
Other costs such as administration, custody and legal fees are charged to the fund as well, and together these make up the expense ratio. The fixed structure gives the manager stability, because there are no sudden withdrawals to fund.
This allows the portfolio to hold less liquid assets, such as unlisted bonds or property, and to use borrowing to raise returns. The trade-off is that investors cannot exit at NAV, and the discount can be uncomfortable when sentiment is poor.
Business readers meet this concept when a company or pension scheme invests surplus cash or when an adviser recommends a listed fund. Understanding that the entity is a company with directors, fees and a share price helps explain why it behaves differently from a typical unit trust or mutual fund.
It also explains why regulators require clear disclosure of fees, leverage and distribution policy.
In practice
Real-world examples.
Example
A US municipal bond closed-end management company is listed on an exchange and managed by a bond specialist. Investors buy shares for tax-advantaged income, and the board reviews the adviser's performance and fees each year.
Example
A closed-end company focused on emerging-market shares allows its manager to invest in markets that are difficult to trade. Since the fund never has to meet redemptions, the manager can hold positions through short-term panics.
Example
A small business owner in Australia considers a listed investment company that follows the same closed structure. She compares its expense ratio with an index fund and checks whether the extra cost is justified by the manager's track record.
Formula
Calculation
Annual expense = average net assets x total expense ratio
Total expense ratio = management fee rate + other expense rate
Suppose a closed-end management company has average net assets of $300,000,000, a management fee of 1.00% and other expenses of 0.25%. Management fee = 300,000,000 x 0.0100 = $3,000,000. Other expenses = 300,000,000 x 0.0025 = $750,000. Total = 3,000,000 + 750,000 = $3,750,000, which is a 1.25% expense ratio. An investor holding $50,000 of the shares bears 50,000 x 0.0125 = $625 of costs a year.Case study
Seen in the real world.
This fictional case is about Seabrook Opportunities Company, an invented closed-end management company. It raises $90,000,000 from investors and employs a manager to buy a mix of corporate bonds, some of which trade rarely.
During a market scare, investors in an equivalent open-end fund rush to redeem and force the manager to sell bonds at poor prices. Seabrook's manager, in contrast, holds on, since shareholders can only sell to other investors on the exchange. In this illustrative story, Seabrook's share price falls to a 15% discount, but the portfolio is intact and the discount later narrows as markets recover.
Watch out
Common mistakes.
- Confusing a closed-end management company with an open-end one. The first has a fixed share count and trades on an exchange, while the second issues and redeems shares at NAV.
- Looking only at the management fee. The total expense ratio, including borrowing costs and other charges, is the better measure of what you pay.
- Assuming a board of directors guarantees good results. The board oversees the manager and fees, but it cannot promise performance or protect against market losses.
Questions
People also ask.
Who runs a closed-end management company?
A board of directors oversees it and appoints an investment adviser to manage the portfolio. The adviser makes the buy and sell decisions within the stated policy.
Why does the share price differ from NAV?
Because the shares trade between investors, so supply and demand set the price. Sentiment, fees, yield and market conditions all influence the discount or premium.
Can it borrow money to invest?
Many can, within legal limits, and doing so is called leverage. It can lift income and returns in good times but it magnifies losses in bad times.
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