Closed-end funds are less common and generally not as familiar to investors as the open-end mutual funds that are a staple of many retirement accounts. However, nearly 2 million households own closed-end funds; as a group, these households are typically older and more affluent than the average investor.1
Closed-end funds are relatively sophisticated investment vehicles that may not be appropriate for everyone. Still, it may be worthwhile to learn more about them and consider whether they could play a specific role in your portfolio.
Fundamental Differences
Most mutual funds are open-end funds, which means shares are issued and redeemed by the fund in response to investor demand. By contrast, closed-end funds issue a fixed number of shares in an initial public offering (IPO), and the fund manager uses that pool of money to purchase securities that reflect the fund’s stated objectives. Shares of closed-end funds are generally not redeemable.
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A closed-end fund is listed and traded on an exchange, similar to a stock, and transactions typically incur a brokerage commission. Both open-end and closed-end mutual funds may hold stocks, bonds, and other types of underlying investments.
Unlike open-end funds, closed-end funds do not need to maintain cash reserves or sell securities to meet redemptions, so they typically have the flexibility to invest in less liquid securities. Closed-end funds also may borrow against their assets, subject to certain limitations, which allows them to use leverage as part of their investment strategy. This can make the funds more volatile and involves additional investment risk.
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Prices in Perspective
Open-end mutual funds are generally priced once daily at the end of the trading day, and the price is based directly on the net asset value (NAV) of the underlying investments. The price of a closed-end fund can change throughout the trading day depending on supply and demand. The market price is often higher or lower than the NAV, so a fund may trade at a premium or discount, respectively.
A closed-end fund priced at a discount is not necessarily inexpensive compared with one trading at a premium, because the “absolute” discounts tend to persist. It may be more helpful to evaluate the “relative” discount, a measure that compares the current discount to the fund’s average discount over the past year.
Distribution Rates
Almost half of all closed-end fund investors are retired.2 Income-oriented investors may be attracted to closed-end funds by relatively high distribution rates. It’s important to keep in mind, however, that share prices often adjust in response to distributions.
Moreover, some funds distribute more money than the investments generate by returning capital to investors. This practice (known as destructive return of capital) is generally unsustainable; it erodes the fund’s NAV over time and/or may cause the fund to cut future distributions.
If you are interested in adding a closed-end fund to your portfolio, you should fully understand the fund’s objectives and underlying investments.
Both open-end funds and closed-end funds charge management and other fees. The return and principal value of all mutual funds fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
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Mutual funds and closed-end funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
1–2) Investment Company Institute, 2013
The information in this article is not intended as tax or legal advice, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek tax or legal advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Emerald. Copyright 2014 Emerald Connect, LLC.
