Closed-End Funds 101

How to Invest in a Closed-End Fund

Closed-End Funds 101
August 5, 2015

Mutual funds are investment vehicles that use pools of investor funds to invest in specific stocks, bonds, or other assets to meet the collective goals of the fund. Most mutual funds are “open-end” funds, meaning that an unlimited number of shares may be issued over the lifetime of the fund. By contrast, closed-end mutual funds have a limited number of shares.

Closed-end funds raise their investment capital only once — through an initial public offering (IPO). After that point, the number of shares never changes. To buy a share of a closed-end fund, you must purchase one of the existing shares.

The price per share, or Net Asset Value (NAV), is calculated the same way for both funds — divide the market value of the assets by the number of shares. Both values change for open-end funds, and thus they are only traded at the end of the trading day when a meaningful NAV can be calculated. However, closed-end funds are traded throughout the day on their listed stock exchange with a share price that is determined based on supply and demand (bid and ask), as is the case with stocks.

Your goal in investing in closed-end funds is to buy at a discount, when the share price is below the NAV of the fund. Assuming the demand drives the share price up closer to the NAV when you sell (in other words, the discount has decreased), you realize a profit.

Closed-end funds generally sell at some sort of discount, so the real investing question is whether the price will rise or fall from that discount regardless of how that price relates to the NAV.

The rise of exchange-traded funds (ETFs) has made closed-end funds less popular, because ETFs do much the same thing as a closed-end fund through tracking an index. As a result, ETFs generally require less active management and therefore lower fees compared to a closed-end fund. However, closed-end funds tend to return higher levels of income due to investing typically in a greater share of income-producing assets.

Before diving into a closed-end fund, check open-end funds or ETFs that have a similar investment goal and compare their performance over time, as well as the fees and expenses, to see which path is likely to give you the best return.

Assuming you decide to go with the closed-end fund, here are a few things to review.

  • Discount vs. Historical Performance – Compare the discount offered to the historical discount average and not to the NAV. The discount rate should head back towards its historical average over time, but a continuing downward trend warrants a little research into the reason why.

  • Debt – Excessive levels of debt (40% or greater) suggests that the fund manager is trying to boost the income return through leverage. The fund still may be worth buying, but the risk is greater and therefore requires greater diligence on your part.

  • Expenses/Management – Check the fees on trades as well as fund management fees, and see how they compare to similar alternative investments. Higher fees must be matched by higher performance. Look over the past performance of the fund manager, as well as his or her duration with the fund.

  • Check Yields – Review the income and yields to see if they are proportional to the underlying holdings. If they appear unusually high or low, look for any sort of distorting phenomena such as a one-off payout or impending news affecting the stock of a company held by the fund.

  • Avoid IPOs – The discount often increases during the months following an IPO. Give the fund some time to settle and reach the initial price equilibrium before diving in.

For further general information on closed-end funds, check out the website of the Closed-End Fund Association (www.cefa.com). Morningstar has a nice directory for you to review and choose from should you opt for closed-end funds – but be sure to do your homework, regardless of which investing vehicle that you choose


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