What Are Closed-End Funds?

What Are Closed-End Funds?

Closed-end funds are often confused with, and mistakenly called, mutual funds. A major difference is that closed-end funds behave more like a stock -- the market value is driven by supply and demand for the shares. On the other hand, an open-end mutual fund continually issues new shares to investors and does not trade on an exchange.

Perhaps the best way to understand a closed-end fund is to compare it with an open-end mutual fund.

Open-End Mutual Funds vs. Closed-End Funds

You can think of a mutual fund as “open-ended” because the cash flow door -- both into and out of the fund -- is always open. In other words, the portfolio manager continues to invest new cash from investors, and the fund company continues to offer new shares of the fund to new investors.

You can think of a closed-end fund, then, as “closed-ended” because the cash flow door -- into and out of the fund -- is always (with a few exceptions) closed. The manager only invests a fixed amount of cash that was raised in an initial public offering of the fund’s shares. If you want to buy shares of the fund, you buy the shares from another investor via a stock exchange. The number of fund shares do not fluctuate based on investor demand.

Similarities in Closed-End Funds and Mutual Funds

Like mutual funds, closed-end funds are:

• A diversified portfolio of stocks, bonds, or a combination of the two
• Professionally managed by an investment advisor
• Either actively or passively managed
• Required to distribute capital gains and dividends to shareholders
• Regulated by the U.S. Securities and Exchange Commission

Differences in Closed-End Funds and Mutual Funds

Unlike mutual funds, closed-end funds:

• Are traded on a stock exchange (NSYE) or over-the-counter (NASDAQ)
• Are bought and sold at market price versus the underlying securities’ value
• Are valued based on supply and demand for the fund
• Can be purchased and sold throughout the trading day
• Use leverage (borrow cash to invest in more assets) to enhance their returns

If you want to know more about the nitty-gritty of closed-end funds, take a closer look at a few of the differences that I have listed below.

Buying and Selling Closed-End Funds

A closed-end fund trades like a stock -- on a stock exchange or over-the-counter -- while an open-end mutual fund is bought and sold directly with the fund company. The cost of the transaction for a closed-end fund is similar to the cost of a stock trade. There are also internal management fees paid to the fund company to manage the fund.

Another cost to be aware of is the bid-ask spread. If you place an order to buy a closed-end fund and, at the same time, place an order to sell the fund, the prices for both would be different. In other words, your cost to buy the fund and the price you would get for selling the fund would be different. For instance, you might sell at the bid price of $9.90, while you would buy at the ask price of $10. This $.10 difference is known as the bid-ask spread and is considered the cost of doing business on the exchange or over the counter.

You can buy both types of funds through a broker. The broker processes the transaction on the stock exchange in the case of closed-ends, or with the fund company in the case of mutual funds.

Net Asset Value vs. Price of Closed-End Funds

It is easy to confuse the net asset value (NAV) of the fund with the fund’s price. To avoid confusion, you can simply think of the NAV as the value of the fund’s holdings (stocks, bonds, cash, etc.) minus any liabilities, divided by the total number of fund shares that are held by investors. Therefore, unlike a mutual fund, the NAV of a closed-end fund is not the price you pay for a share of the fund.

Closed-end funds are often bought or sold at a discount to their NAV. In other words, if a closed-end fund owns 100 stocks that have a combined value of $1,000,000 with $0 liabilities and 100,000 shares outstanding, the fund has an NAV of $10. Investors might not value the portfolio manager’s ability to pick stocks, however, so they might only be willing to pay $9 per share of the fund. So, this fund would be trading at a discount of 10% to its NAV.

Why Do Fund Companies Choose the Closed-End Structure?

There are many reasons a fund company might decide to structure their fund as a closed-end fund rather than an open-end mutual fund (and vice-versa). It could be that the fund company has a particular niche that is better served through closed-ends. For example, if a fund company wants to manage a fund that holds securities that are not easy to trade (illiquid, such as stock of a very small company that is rarely traded on the stock exchange), then they might form a closed-end fund.

Another reason to form a closed-end fund, which will also help clarify the previous reason, is because the fund managers of closed-end funds are not forced to sell a particular security when an investor wants to sell his/her shares of the fund. For example, let’s say we have a manager who is running two funds that differ only in structure -- one is a closed-end fund, while the other is an open-end mutual fund. The funds both hold Wal-Mart and Target shares. The fund manager loves both stocks.

If an investor wants to sell his/her shares of the closed-end fund, then there is no problem; the fund manager is able to continue to hold both stocks because the investor goes to an exchange to sell his/her shares to another investor. On the other hand, because investors in a mutual fund go to the fund company to redeem his/her shares, the fund manager must sell either Wal-Mart or Target shares in order to meet redemption needs and raise cash for the investor.

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