You’re most likely familiar with mutual funds. When investors refer to “mutual funds,” they’re commonly referring to an open-end fund.
While closed-end funds have many similarities, there are some significant differences too. Understanding closed-end funds will help you to make a more informed decision regarding whether they may be beneficial investment vehicles for you.
Since it’s always easier to start with something one already knows, here are the principle differences between open-end and closed-end funds.
1. Closed-end funds are generally closed to new capital after the initial IPO.
* Open-end funds are continuously gaining and losing investors; when they lose an investor, they lose the capital that investor had invested with them. Likewise, when a new investor comes aboard, they gain capital.
* Closed-end funds essentially have whatever capital was invested with them when the fund first began operations. They do have some options to increase their capital, but it is normally not through the process of issuing more shares. This will be explained below.
2. Closed-end shares trade on stock exchanges like a stock.
* Like stock, closed-end funds are originally available from the company itself in an initial public offering (IPO). After that, the fund shares are generally only available on the secondary market. So, like a stock, you would have to purchase or sell your shares to another investor.
* Also, open-end fund shares are typically only available at the end of the day at the closing price. Closed-end funds are available all day long.
3. A closed-end fund sells at a premium or discount – not its NAV.
* Open-ended funds are priced based on the net asset value (NAV) of the fund. This is simply the total value of the fund’s holdings and cash on hand (minus any debt the fund may have) divided by the number of shares that have been issued by the mutual fund company.
* Closed-end funds are not priced based upon their NAV, but – like stocks – upon the current market conditions and what another investor is willing to pay for it. They’re almost always priced at a discount relative to the value of the underlying assets.
4. A closed-end fund can utilize unlisted securities.
* Unlisted securities are those stocks that aren’t listed on the stock exchange, either because they cannot meet the requirements, or because they simply don’t want the restrictions that come with being listed.
* Unlisted securities can be riskier, but the rewards can be greater as well. Open-end funds can be a more conservative investment, but it really depends on the personality of the closed-end fund. There is a wide range of risk within each group.
5. Closed-end funds can use leverage to increase possible returns.
* Closed-end funds can issue preferred stock, bonds, and more to raise more capital for investing. So closed-end funds can borrow to enhance their returns. An open-end fund would have to sell more shares to accomplish the same thing.
The real advantage of a closed-end fund is the benefit of professional management and significant diversification at a lower expense than the typical open-end mutual fund. Since closed-end funds don’t have to sell their product, the marketing and sales expenses are largely non-existent. This results in lower operating or management fees.
The fund managers are not quite as restricted as are the managers of open-end funds. The risk can be greater, but in theory, the opportunities are greater as well.
Closed-end funds combine features of both stocks and open-end funds. The information above should give you a good, basic understanding to better investigate closed-end funds and determine if they’re a good fit for your portfolio.