Open vs Closed Investments & Funds

One day during the Gold Rush in the 1800s, three strangers start to dig in the one remaining plot of land to mine. They agree upfront to split anything they find evenly. After weeks of digging, they make an amazing discovery, to find both diamonds and gold in their plot! They are ecstatic, and secretly take what they find to a jeweler to establish their value before they keep digging. 

The jeweler gives them bad news: the stone is not actual gold, but fool’s gold, and the diamonds are so cracked that they can only be used for industrial purposes, not valuable fine jewelry. Thinking that they have something worthwhile, the miners go back and continue to dig and find much more of the same. 

When they finish and both cavities dry up, one miner offers to take the fool’s gold and pay the other two miners for their share. The second miner then says that he’d like to do the same for the flawed diamonds and would pay the remaining miner for her share. The third miner agrees to take her share of the money for both the fool’s gold and the diamonds. 

Walking away with their goods, the first two miners can barely contain their excitement. The first miner’s uncle is a diamond cutter who knows how to cut low-quality diamonds to look clear and precise enough to fool the average person into purchasing it. The second miner knows people a couple cities over who don’t know the difference between fool’s gold and real gold. These folks would buy the fool’s gold as if it was real gold at full price. The first two miners both laugh inside at their own brilliance and at how they will profit at the expense of the other two miners. These two miners believed the other two miners took the worse deal.

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Both of the first two miners are right, and both are wrong. Find out why below.

Who's Right, and About What?

The question of which miner got the best deal really depends on the perspective and information each of them have. Miners one and two are driven by extracting the most value that they can right away, in finance this approach is called “maximizing short-term profits.” The two miners believe that it’s not their fault that the other miners did not know about their special connections and/or knowledge. In fact, the two miners believe it is not their duty to share information with one another. This approach results in another finance term called “asymmetric information” and describes the way most people perceive finance.

Why Is Each Miner Right?

The basic reasons why the miners are right is because each miner believes that they will achieve their major objectives: maximizing the value of their efforts. Given the information at their disposal they believed they would make more money than what the other believed they could get. They are actually even more right because they offered to buy the fool’s gold and cracked diamonds at what the others agreed were a fair price, something that cannot be said of what many people believe in finance.

Why Is Each Miner  Wrong?

While the three miners in this story are all treated equally, what is missing from this thinking is the effect on the people who will ultimately buy the fool’s gold and cracked diamonds. At the end of the day, both miners plan to make more money by selling the average person one thing, when in fact it’s something else.

The two miners are allegories for the two main types of structures for real estate investments and real estate funds: closed-ended and open-ended. While each may have their own opinion on the right choice and what the benefits are there are also those who can but not always misuse the structures to enrich themselves at the costs of the investors.

What are Closed-End Investments?

A closed-end fund is a type of real estate fund where a manager raises a fixed amount of money at the beginning of the fund, and then “closes” the fund to do investments over a fixed time period and investors are unable to take their money out. The amount of time these funds hold investors' money can vary, but the timeframes generally range from 3 years to 10 years. Once the investment period ends, the manager sells all the real estate it has invested in and returns money to investors, hopefully with a big profit.

Closed-End Advantages For Investors

The major selling point of a closed-end investment is that, because a manager can have access to a steady stream of money, they have the time to buy into real estate, make major improvements, and benefit from increased rents and profits. This allows the investor focus on taking the time to make long-term and meaningful improvements on the properties, and is considered key to not requiring rash short-term decisions that let a property make real value and sell for a large profit later.

The other issue considered an advantage to many is that, because they are “closed,” they don’t seem to have crazy price swings like the stock market. By holding their money for a fixed time and not expecting any short-term profits, some investors feel like the investments are less volatile and they can sit back and let the professional manager make investment decisions on their behalf.

Closed-End Disadvantages For Investors

While there are some good things that closed-end investments can offer for an investor, like the miner with the cracked diamonds, there are lots of things for an investor to think about:

• Locked-Up Money: Of course everything can be fine if an investor doesn’t need to access their money over the next 3, 5, 7 or 10 years, but if an emergency happens, they are unable to sell and may suffer from illiquidity problems and possibly falling prey to distressed secondary investors. If you are not sure whether you might need invested money over this time period, think twice before investing.
• Management Fees: Typically funds charge some type of management fee every year the entire investment timeframe, and investors have to pay this whether the investment/manager does well or not. Typical private equity fees are generally 2%, which would mean that if you invested $100,000 in a 10 year investment, you will be guaranteed to pay $20,000 of it in fees no matter what. And worse, many platforms today charge higher fees, with some double or more than the typical at 4% or 5%.
• Bad Manager: If you pick a manager who cannot execute on what they promised, you still can’t take your money out for the entire time of the fund, and they still get the management fee. 
• Additional Unshared Fees: In addition to constant management fees, many managers provide bonuses for their employees through additional fees that are charged to the investors. These can include acquisition fees (charged whenever a new deal is bought), disposition fees (charged whenever a deal is sold), and sometimes property management fees and/or construction management fees that go to an affiliated entity that the manager owns but does not share with the investor.
• Bad/ Inflexible Strategy: People raising money will typically try to raise around things that are popular at the time, but may not be popular when the strategy ends. Examples could be developing an office building expecting WeWork to buy out the whole thing in 2016 or completing renovations on a luxury hotel in Moscow right before the Russia-Ukraine conflict. Because the manager has raised money to follow a very specific investment strategy, they have to complete it or return your money (not including management fees). 
• No Control: In the vast majority of these deals, once you invest, you give the manager control to do whatever they want as long as it mostly fits the stated investment strategy. 
• Reversion + Bad Luck: Since the big returns for closed end investments are focused on reversion selling at the end of the period, even if everything works out well and the manager does a great job to finish the project well, some macroeconomic issues can still affect the investment quite a bit when it’s time to sell. For example, if a strategy required a manager to sell during early 2020, it could have to sell during the beginning of COVID-19.

So, like the first miner, closed-end investments may indeed be diamonds, but investors need to carefully scrutinize whether the diamonds are of the quality as they are advertised, or at least know where the cracks are and be ok understanding the risk of buying.

What are Open-Ended Investments/Funds?

If closed-ended investments require a long lockup, open-ended investments are basically the other side of the coin. These open-ended investments are typically held in funds that have various types of real estate that produce some income. They are advertised to provide people with the opportunity to sell their investments with more regularity. However, there is a lot for investors to consider here too.

Open-End Fund Advantages For Investors

The major selling point of an open-ended investment is that it is supposed to have more liquidity. Open-end real estate funds  allow investors to buy in and sell the fund at more regular intervals determined by the fund’s manager, providing flexibility to investors who may need access to their capital before the end of their desired investment period. On the other hand, investors can theoretically decide to keep their assets in an open-ended fund for as long as the fund is open.

Another benefit of open-ended funds is that these funds are generally invested in more income-producing properties that pay out an investor dividends while they are invested. That way, an investor can get income more regularly for their investment. 

Open-End Fund Disadvantages

With the advantages, it might seem like open-ended funds are obvious winners. However, just like possible fool’s gold, there can be more than meets the eye:

• Run On The Fund: After problems likr Silicon Valley Bank and other regional banks, you may have heard more about concept of a “run on the bank,” where everyone goes to withdraw their money from a bank at the same time, and a bank can’t pay everyone back because it has many of its assets tied up in other illiquid loans and can’t sell them instantly. The same thing can happen in open-ended real estate funds, and managers can be forced to sell the illiquid real estate assets to a distressed investor for much less than it’s worth. 

• The problem is that whatever caused a run on a fund may be related to the manager itself or a macroeconomic event that will cause the real estate values in its fund to go down. These last investors may get back much less for their investment.

• Sell Windows: While open-ended funds are typically created in a way to allow people to sell more often, that does not mean that they can sell whenever they want. These funds generally limit the specific times an investor spends once a year, once a quarter, and sometimes once per month. Investors also often have to give notice of selling of at least a month and sometimes 3 months, so if they miss the window, they have to wait until the next hold period. That can be restricting for an investor who needs to access their money right away that an investor should understand before investing.
• Lock-Up Period: Most open-ended funds require some amount of time to lock up capital to ensure that they have certainty so that they can buy assets. These are generally less time than closed-end  investments and funds, but times can range from a year or more. 
• Management Fees: Open-end funds also charge management fees, but these are typically less concerning because they come out of the income that they return to investors.
• Additional Unshared Fees: Just like closed-end funds, many managers provide bonuses for their employees through additional fees that are charged to the investors. These can include acquisition fees (charged whenever a new deal is bought), disposition fees (charged whenever a deal is sold), and sometimes property management fees and/or construction management fees that go to an affiliated entity that the manager owns but does not share with the investor.

Open-end funds can be compared to the second miner who knew he could sell fool's gold as the real thing. While investors may believe they are getting a good investment with an ability to sell their investments when they need, they need to make sure that they look past the hype and understand the terms and know exactly what they are investing into. 

Conclusion

In the end, we see that there is no strict right or wrong in closed-end and open-ended investments or funds, but really a matter of perspective. As an investor, you can learn to understand the specifics of each potential diamond and gold bar you come across.

But as each of the miners rejoice over their profits they take home, what happened to the 3rd miner? She knew what each of the other two were doing, but she took the cash anyway. She was a geology expert who knew that where fool’s gold and cracked diamonds were found, there were actually real huge diamond deposits a few hundred feet deeper. She took the money, invested in a drill, and found the jackpot! She then decided to share the riches with the communities nearby and give the real diamonds and teach everyone how to tell what was fake. Her name is Kopa.

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