What are Closed-end Funds?
Despite the name similarities, closed-end funds share little in common with mutual funds (also known as open-end funds). Sure, investors pool money together to purchase stocks or bonds and a professional manages the fund, but that's where the similarities end.
It helps me to think of a closed-end fund as a company. But instead of being a company that makes products, this one buys stocks of other companies. The closed-end fund "company" still has it's own stock, which is traded on an exchange and trades above or below its underlying value, or net asset value (NAV), in this case.
If you're still confused, try my glossary definition of a closed-end fund.
There are approximately 800 closed-end funds, valuing around $371 billion in early 2005. It's a big industry, but much smaller than the open-end, "mutual fund" industry. Closed-end funds are similar to ETFs, but they are actively managed (ETFs are passive, index-like funds).
What's the Difference Between Open-end and Closed-end Funds?
Open-end funds, also known as mutual funds, are open to new investors (they can create as many shares as needed). However, when a mutual fund closes to new investors, that does not make it a closed-end fund. When a mutual fund closes, it still allows current investors to buy more shares and when those investors want to sell their holdings, they don't need to find a buyer.
Closed-end funds, on the other hand, have a fixed number of shares. Much like a new publicly traded stock, closed-end funds have an IPO. They also trade according to market demands. Every seller must have a buyer.
What are the Advantages of Closed-end Funds?
- Closed-end funds can sometimes be purchased at a discount, meaning they are trading below their NAV.
- Closed-end funds can sometimes be sold at a premium, meaning they can be sold for more than their NAV. Remember, buy low, sell high.
- Closed-end funds have access to some investments and strategies that mutual funds shy away from. Examples include buying illiquid securities or using leverage.
What are the Disadvantages of Closed-end Funds?
- As mentioned above, the fund shares could be trading at a discount or premium, which could work against you.
- Closed-end funds are plagued with broker trading fees.
- Closed-end funds are generally riskier.
- Closed-end funds are less liquid, meaning they are much harder to sell. Unlike mutual funds, the shares are not redeemable (meaning the company does not have to buy the shares back)
- Closed-end funds tend to charge between 1-2 percent a year for management fees.
- Closed-end fund price information is not always available.
- As a general rule, open-end funds attract better managment talent because they can grow by attracting new investors over time.
Bottom Line on Closed-end Funds
Though closed-end funds might be attractive to people trying to take advantage of pricing inefficiencies, I advise most investors to stick to the open variety: mutual funds (or open-end funds). The fees and liquidity associated with closed-end funds make them less desirable.
