Frequently Asked Questions About Closed-End Funds and Their Use of Leverage

What are closed-end funds?
Closed-end funds are professionally managed investment companies. Closed-end funds differ from other types of investment companies because, like publicly traded operating companies, closed-end funds issue a fixed number of shares which typically are listed on a stock exchange. Once issued, closed-end fund shares are not typically purchased or redeemed directly by the fund, but instead are bought and sold in the open market. The fund's common shareholders own these shares.

What types of securities do closed-end funds invest in?
Closed-end funds invest in a wide variety of securities, including common stocks, preferred stocks, high-yield bonds, municipal bonds, and foreign securities.

How many closed-end funds are there?
As of the end of December 2007, according to ICI data, there were 668 closed-end funds with more than $314 billion in assets.

Assets of Closed-End Funds
(billions of dollars)

What types of stock do closed-end funds issue?
They all issue common stock. In addition, under Section 18 of the Investment Company Act of 1940, closed-end funds are permitted to issue one class of preferred stock. Preferred stock differs from common stock in that preferred shareholders are paid dividends but do not share in the gains and losses of the fund. According to ICI data, as of December 2007, 347 closed-end funds issue preferred stock.

Why do closed-end funds issue preferred stock?
Issuing preferred stock allows a closed-end fund to raise additional capital, which it can use to buy more securities for its portfolio. This strategy, known as "leveraging," is intended to allow the fund to produce higher returns for its common shareholders. Funds can also leverage by borrowing money or issuing debt securities. Funds invest the additional capital raised through leverage in securities that are expected to earn a rate of return that exceeds the short-term borrowing cost of the preferred stock or other leveraging instrument. The additional income, or "spread," is then available for the benefit of common shareholders.

Is leverage commonly used?
According to data reported by Thomas J. Herzfeld Advisors, Inc., a firm devoted to research, analysis, and investment in closed-end funds, 71 percent of closed-end funds used some form of leverage in 2007.

Does the use of leverage present any risks?
Yes. The net asset value of the common shares and the returns earned by common shareholders in a leveraged fund will be more volatile than those of common shareholders in a closed-end fund that does not use leverage. In addition, if short-term interest rates rise, the cost of leverage will increase, most likely reducing the returns earned by the fund's common shareholders.

What type of shareholder protections do closed-end funds offer?
Closed-end funds are governed by the Investment Company Act of 1940, a law that shapes how all publicly offered funds must be structured and operated. All closed-end funds therefore must meet certain operating standards, observe strict antifraud rules, and disclose complete information to investors. These laws are designed to protect investors from fraud and abuse.

In addition, like all registered investment companies, closed-end funds have a board of directors-elected by the fund's shareholders-to oversee the management of the fund's business affairs and to protect the fund's interests, taking into account the interests of all shareholders.

Do preferred shareholders vote for fund directors?
Yes. Section 18 of the Investment Company Act provides the preferred shareholders with the exclusive right to elect two fund directors. Preferred shareholders also typically vote together with the common shareholders to elect the remaining fund directors. In addition, Section 18 provides preferred shareholders with the right to elect a majority of directors if the fund does not pay dividends to the preferred shareholders for a period of two years.

Do the directors elected by the preferred shareholders have distinct responsibilities to those shareholders?
No. Neither the Investment Company Act nor the jurisdictions in which most closed-end funds are organized (Maryland and Delaware) assign distinct duties to directors elected by preferred shareholders. Those directors, like all fund directors, owe a fiduciary duty to the fund to act in a manner that protects its interests, taking into account the interests of all shareholders, both common and preferred.

What is "auction rate" preferred stock?
Auction rate preferred stock is a type of preferred stock that pays dividends at rates set through auctions run by an independent auction agent. Dividend rates typically are reset through auctions held every seven or 28 days. An auction is governed by a set of procedures established by the closed-end fund and its auction agent. Typically, investors submit bids through a broker-dealer, who, in turn, submits them to an auction agent. Auctions may have a single broker-dealer or multiple broker-dealers, who may submit bids for their own account and on behalf of customers wishing to purchase the securities. Bids are filled to the extent shares are available, and sell orders are filled to the extent there are bids. All filled bids receive dividends at the new set dividend rate.

What is fixed rate preferred stock?
Fixed rate preferred stock has a fixed dividend rate which is set at the time of issuance based on market conditions. Fixed rate preferred stock has not been affected by recent events in the auction market.

What is a failed auction?
An auction fails when there are more shares offered for sale in the auction than there are bids to buy shares. As a result, existing holders of preferred stock who wanted to sell their shares generally are not able to do so in that particular auction.

Is a failed auction a default by the closed-end fund?
No. Holders of preferred stock continue to receive dividends from the closed-end fund although at a different rate.

Have closed-end funds had to pay significantly higher dividend rates as a consequence of recent failed auctions?
No. In the event of a failed auction, closed-end funds pay a dividend rate based on a formula established when the shares were first issued. This "maximum" or "penalty" rate has only varied slightly from the rates determined at recent auctions. In this respect, closed-end funds differ from municipalities that have faced failed auctions recently. According to press reports, many municipalities have had to pay maximum dividend rates that greatly exceed the rates that had been set through auctions.

What is the effect of a failed auction on preferred shareholders?
These shareholders will continue to receive dividends at the maximum rate, but will not be able to sell their shares through the auction process. As discussed below, it is possible that broker-dealers may try to trade preferred shares outside of the auction process (i.e., facilitate the creation of a secondary market).

What is the effect of a failed auction on the fund's investments and the fund's common shareholders?
Failed auctions do not directly affect the portfolio securities held by funds or the ability of common shareholders to sell their stock. If the cost of leverage increases, however, the fund's current earnings may decline.

(The Financial Industry Regulatory Authority (FINRA), a self-regulatory organization for securities firms in the U.S., outlines investors' options in the event of a failed auction.)

Are failed auctions caused by any concerns about the credit quality of closed-end funds?
No. The assets of closed-end funds, which are valued on a daily basis, are the collateral underlying the issuance of the preferred shares. Funds are required by the Investment Company Act to have at least $2 of assets for each $1 of preferred stock issued. Preferred shares typically have a AAA rating from one or more rating agencies; these ratings are based on both the asset coverage behind the preferred shares and the quality and diversification of the collateral.

As stated above, recent auctions have failed because of liquidity issues (i.e., there were more shares offered for sale than there were bids to buy shares), not because of credit quality concerns. The liquidity problems may have arisen because some broker-dealers who customarily placed bids for their own accounts in auctions did not place bids in recent failed auctions. However, broker-dealers are not, and never have been, legally required to bid in an auction.

Are the failed auctions related to recent problems experienced by municipal bond insurers?
Failed auctions involving closed-end funds do not appear to be directly related to problems experienced by bond insurers. Closed-end fund preferred shares rely on their asset coverage and their underlying portfolio diversification and credit quality, not on a bond insurer, for their AAA ratings.

Have the credit ratings of closed-end funds been affected by the failed auctions?
No. To date, the credit ratings of closed-end funds have not been downgraded. As stated above, ratings are based on both the asset coverage behind the preferred shares and the quality and diversification of the collateral.

Is there a secondary market for auction rate preferred stock?
No. Some broker-dealers have discussed attempting to facilitate a secondary market, but it is unclear what will be the outcome of those efforts.

Where can I find more information on closed-end funds?
Additional information about closed-end funds can be found at the Investment Company Institute's public website. ICI has prepared a guide about investing in closed-end funds and tracks the assets of the closed-end fund industry.

March 2008