Close End Mutual Funds Explained

A closed-end fund is a mutual fund that is traded on a stock market every business day, all day long. It pools the assets of investors to buy a variety of assets, which increases the diversification of each investor’s portfolio. Closed-end funds come in many styles, so it is important for investors to do their research before they chose a fund.

One free source of information about closed-end funds is cefconnect.com. There anyone can enter the symbols for a selection of closed-end funds. Among other things, the site will return charts that compare the net asset values of funds to their market prices.

In general, closed-end funds tend to trade at a discount to their net asset value, except when they are first offered to the public. It’s possible to buy closed end funds on sale. There are exceptions, such as the funds that cover countries otherwise difficult for foreigners to buy shares in, and certain specialized bond funds.

As a rule though, the discount to asset value fluctuates, and after the Initial Public Offering, the IPO, it tends to fluctuate in the investor’s favor. This discount is a primary reason to buy a closed-end fund. For this reason, investors will want to watch the ups and downs of their chosen fund, and try to buy shares at the maximum discount, other things being equal. Prudent investors naturally try to avoid overpaying.

Why do closed end funds trade for less than the value of the stocks and/or bonds they hold? No one is quite sure. It may have to do with liquidity, which is arguably less than with open-end funds (ordinary mutual funds). Sometimes it has to do with leverage: some funds are extremely leveraged and thus extremely risky.(They should sell at a discount.)

It may have to do with taxes, which are sometimes over-sized. It may have to do with the lack of glamour in this neglected corner of the market. Closed-ends are actively sold when they come public, but after that, the unprompted buying public may lose interest. Therefore, closed-end funds may sell at a price higher than the value of the assets they own during the Initial Public Offering, but at a discount afterwards.

Whatever the reason is, the discount gives a patient investor a chance to buy a fund that will pay a higher dividend than he or she would get if the assets were bought at full price. That dividend may be safer than it would be if it were covered by a skimpier dollar amount of assets. The discount may also shrink in a rising market (if one occurs), supercharging returns.

There is nothing mysterious about the structure of a mutual fund. Any mutual fund pools investor’s funds in order to invest in a variety of assets. An open-end fund, the kind people automatically think of when they hear “mutual fund”, creates more shares when new customers send it more money. When investors redeem shares they are paid the value of their portion of the fund’s assets at the time they sell, and their shares disappear.

Therefore, the number of shares that an open-end mutual fund is managing may swell and shrink with the popularity and success of the fund. The value of all the shares of an open-end fund will be equal to the value of all the assets, minus expenses.

Not so with a closed-end fund. In general, a closed-end sells shares at an IPO, and then manages the money it has raised. If new investors later want to participate in the fortunes of the fund, they must buy shares on the open market, at the current market price, not from the fund.

The managers may sometimes do a secondary offering of shares later, to increase the size of the fund. On the other hand, they may buy back shares, if they decide that the shares are undervalued enough to make this the best use of shareholder’s capital. Otherwise, the number of shares in a closed-end will not change. Closed-end funds have a price that is determined by the market, and a stable number of shares.

Closed-end funds come in many varieties. There are funds that pay a dividend every month, for investors looking for income. There are balanced and government bond funds for investors interested in capital preservation. There are many conservative closed-end funds that buy municipals, and others that buy all too exciting high-yield bonds.

There are many closed-end funds that specialize in the stocks of a single country or a single region. There are sector funds, and many that cover huge segments of the market, or of the world. This variety makes it possible to say, without too much exaggeration, that anything an investor wants from a stock or bond, he or she can get from a closed-end fund, but with more diversification, and possibly, if the fund is bought at a discount, on sale.