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What Are Closed-End Funds? How Do They Work?

Closed-end funds are investment vehicles that bear a passing resemblance to mutual funds and exchange-traded funds (ETFs). All three fund types are pooled investments that sell shares to investors and use the proceeds to build a broadly diversified portfolio of assets. But the similarities between closed-end funds and their mutual fund and ETF brethren end there.

How Closed-End Funds Work

Closed-end funds are “closed” in the sense that once they raise capital, via an initial public offering (IPO), no new money flows into or out of the fund. An investment company manages a closed-end fund’s portfolio, and its shares actively trade on a stock exchange throughout the day.

Unlike ETFs or mutual funds, outside investors buy and sell the shares of closed-end funds on the secondary market. The shares are not issued and repurchased by a closed-end fund’s management.

After a closed-end fund’s IPO, “the supply of shares is typically fixed at that point which is why it is called a “closed-end” fund,” says Jon Ekoniak, managing partner at Bordeaux Wealth Advisors, an investment firm based in Menlo Park, Calif.

Mutual funds and ETFs are open-ended funds. They “open” because when outside investors buy and sell shares, the shares are issued and repurchased by the fund’s management—rather than being sold and purchased by other outside investors.

Most closed-end funds are listed on the New York Stock Exchange (NYSE) or the Nasdaq, where they are actively traded until the fund reaches its objective, liquidates itself and returns capital to its investors.

Closed-End Funds and Liquidity

Open-ended funds have no limit on the number of shares they can issue, and capital flows into and out of the funds freely as new shares are issued and repurchased. Mutual fund and ETF managers will keep selling shares as long as there’s demand for them.

As a result, mutual funds and ETFs provide greater liquidity than closed-end funds. There’s always a buyer for your shares—the fund’s management—so you can get cash for your investment on short notice. But this also requires open-ended funds to hold cash in order to buy back investor shares if need be, which prevents them from fully investing all of their assets at any given time.

Closed-end funds, meanwhile, invest virtually every cent because they aren’t required to constantly repurchase shares. This also lets them invest in less liquid asset categories and deploy leverage. Leverage in particular can be a risky investment strategy as it can magnify results, both positively and negatively. But shares of closed-end funds are less liquid, as your ability to sell is limited by available market demand.

Closed-End Funds, Trading Price and NAV

Net asset value (NAV) is an investment fund’s total assets minus its debts, divided by the number of outstanding shares. In other words, it’s the amount of assets each share of a fund is entitled to if the fund were to liquidate.

The NAV of a mutual fund tends to be identical to its share price, since mutual fund shares are not directly traded on an exchange. Every day, management issues and repurchases shares to balance the NAV.

For securities that actively trade on a stock exchange, like ETFs and closed-end funds, share prices and NAVs don’t have to align. Sometimes share prices may be higher—or lower—than the actual value of the fund’s assets. This means, practically speaking, you may be able to buy shares of closed-end funds at a premium or discount.

“It’s not unusual to see [closed-end funds] trading 5% to 10% below net asset value,” says Todd Jones, chief investment officer at Gratus Capital, an Atlanta-based investment advisory firm. This discount could allow fixed income investors unsatisfied with a low-rate environment to effectively raise their yield.

This disparity between NAV and trading price also creates a unique opportunity for closed-end fund investors. They gain two paths to profitability. “First, if the NAV of the holdings rises; and second, if the discount narrows or the premium widens,” says Robert R. Johnson, professor of finance at Heider College of Business at Creighton University.

Closed-End Fund Types

Currently, there are approximately 480 closed-end funds trading on U.S. stock exchanges. For context, there were roughly 2,200 ETFs and almost 8,000 mutual funds trading in the U.S.

Tech Closed-End Funds

Technology funds are among the hottest and higher-performing closed-end funds right now.

For example, the BlackRock Science and Technology Trust (BST), with a market value of approximately $1.3 billion at the beginning of 2021, has generated a 311% total return since it rolled out in 2014. Compare that to the S&P 500 117% returns and the Nasdaq’s 217% returns over the same time period.

Income Closed-End Funds

Traditional income funds are also proving to be an attractive play for closed-end fund investors this year.

Case in point: the Pimco Dynamic Income Fund (PDI), with a market value of $3.1 billion in early 2021. The bond-heavy fund has returned approximately 192% in total returns since 2012 inception. Over the same time period, the benchmark Bloomberg Barclays US Aggregate Bond Index has returned 31%.

Real Estate Closed-End Funds

Finally, real estate is another area where closed-end funds may stand out.

The Cohen & Steers Quality Income Realty Fund (RQI) has delivered 426% in total returns since it was introduced in 2002, which bests the SPDR Dow Jones REIT (RWR)’s rate of 372% over the same timeline. The fund also trades at a modest discount to its NAV, making it an even better deal for RQI investors.

Closed-End Fund Performance

While closed-end funds may shine in particular industries, though, overall they’ve lagged broader market performance. From the decade spanning February 2011 to 2021, they saw average total returns of about 107%, compared to the 257% total returns of the S&P 500.

This total return value is important to keep in mind as closed-end funds often offer attractive distribution percentages—they average over 7% in payouts annually compared to S&P 500 funds’ 1.45%. But when accounting for price growth and distributions, they still overall trail market returns.

And be sure to keep in mind that this also doesn’t account for the greater tax burden closed-end fund holders may face. Though dividends from index funds often receive lower, preferential tax rates, closed-end fund distributions include dividends as well as realized capital gains and profit that may face higher, short-term capital gains taxes.

* The Content is for informational purposes only, you should not construe any such information or other material as legal, tax, investment, financial, or other advice. Nothing contained on our Site constitutes a solicitation, recommendation, endorsement, or offer by De Angelis & Associates or any third party service provider to buy or sell any securities or other financial instruments in this or in any other jurisdiction in which such solicitation or offer would be unlawful under the securities laws of such jurisdiction. All Content on this site is information of a general nature and does not address the circumstances of any particular individual or entity.

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