What are the Risks of Closed-end Mutual Funds and UITs

Both closed-end bond funds and UITs are subject to interest-rate risk. When market rates of interest increase, generally prices of stock issues held in both UITs and closed-end funds decline. This means lower fund share prices. Moreover, this is a double-edged sword in that if there is selling pressure on the fund’s shares, the decline in share prices will be even greater than the decline in NAV. The opposite is true in that if interest rates decline, there will be appreciation in the assets and, of course, in the share price. For both closed-end funds and UITs, there is the risk that share prices will fall way below NAVs owing to excess selling pressure in the stock markets. Then, of course, the danger arises of not being able to recoup the original price paid for the shares when selling. This is a common phenomenon experienced by closed-end funds and UITs.

For UIT shareholders, there is the added risk of not getting back the full amount of their original investments at maturity. This can be caused by a number of factors. The composition of the trust’s assets, commissions, high management fees charged to the trust; and the use of leverage are all factors that can add to the risk of loss of principal. The managers of UITs and closed-end bond funds charge in many cases very generous annual fees, in addition to their up-front commissions on the original sale of the shares. This means that these funds will have to earn spectacular returns in order for the managers of these funds to be able to collect their fees without eroding yields significantly; also, they will have to rake up some capital gains to be able to recoup the sales commissions in order to return to the shareholders their entire investments at maturity. This explains why many UITs use leverage and resort to derivative securities as ways to try and boost their returns.

The types of investments that a fund or trust holds has a marked effect on the NAV, as well as the volatility of the share price. Unfortunately for the original shareholders of closed-end bond funds and UITs, there is no way of knowing the composition of the portfolio investments when they originally subscribe to the shares of the fund/trust. This is so because only after the original shareholders invest their money to buy the shares do the managers of the fund or trust buy the investment assets. Thus original shareholders may not be able to evaluate the levels of risk of the assets until the portfolio has been constituted. The composition may include the stocks of highly risky companies. Investors then trying to exit the fund or trust may experience losses from the decline in share price. If there is an exodus of shareholders from UITs and closed-end funds, shareholders may find it difficult to sell their shares without taking large losses.

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