It’s a case of sibling rivalry. Closed-end funds are one of two major kinds of mutual funds, alongside open-end funds. Since closed-end funds are less popular, they have to try harder to win your affection. They can make a good investment — potentially even better than open-end funds — if you follow one simple rule: Always buy them at a discount.
Like many siblings, these two are as different as they are alike. Here’s what you need to know about closed-end funds and whether you should invest in one.
Closed-end fund definition
A closed-end fund, or CEF, is an investment company that is managed by an investment firm. Closed-end funds raise a certain amount of money through an initial public offering, or IPO, after which it can list shares on a stock exchange. Like mutual funds and ETFs, closed-end funds invest in a basket of securities.
Closed-end funds vs. open-end funds
A closed-end fund is not a traditional mutual fund or exchange-traded fund. Open-end funds, such as mutual funds or ETFs, take in money from new investors, issue additional shares and buy back shares when investors are looking to sell. In contrast, closed-end funds offer a particular number of shares after raising a fixed amount of money through an IPO.
Open-end funds can sell as many shares to investors as they want. However, they sell shares only at the fund’s net asset value per share. That's the market value of all the fund’s holdings, minus any owned through borrowing on margin, divided by the number of shares. For example, if a fund has net assets of $100 million and 5 million shares, the price per share is $20 ($100 million divided by 5 million).
This practice prevents new investors from diluting the holdings of the fund’s current investors. At the end of each trading day, the fund calculates its net asset value, and new investors can buy the fund’s shares at that price. Then, the fund puts that money to work by buying new securities — stocks or bonds, for example.
Open-end funds are common in employer-sponsored 401(k) plans because their expenses tend to be lower.
In contrast, a closed-end fund sells a fixed number of shares during its IPO and never reopens the fund to sell more. Investors can buy and sell shares throughout the day, and the fund’s price on the exchange fluctuates during the day, much like a stock. A closed-end fund’s market price can be the same as or higher or lower than its net asset value per share.
Understanding closed-end funds
Closed-end funds are much less common than open-end funds, and they have some other features and risks not usually found in open-end funds:
Because closed-end funds are often actively managed by an investment manager who is trying to beat the market, they may charge higher fees, making them less attractive to investors.
Closed-end funds frequently use leverage — borrowing money to fund their asset purchases — to increase returns. That strategy is a double-edged sword: It improves returns when investments are rising but magnifies losses when stocks are falling.
Closed-end funds tend to pay out higher dividends to investors in part because they use leverage to help boost returns. Again, that works well in a rising market, less so in a falling one.
The potential for higher dividends makes closed-end funds attractive, but the potential downside is greater, too, not only because of the leverage these funds use but also their structure. Because they trade throughout the day, closed-end funds can trade below their net asset value for a long time — and they often do. But that’s also an opportunity for a smart investor.
Buying closed-end funds at a discount
Your best odds of success come when you buy a closed-end fund at a discount to its net asset value. That’s easier to do than you might think since many funds trade at discounts and the fund’s net asset value is published quarterly or monthly by the investment manager. If the trading price is lower than the net asset value, the fund is trading at a discount.
Many investors aim to buy closed-end funds at a substantial discount. How substantial? It’s not uncommon for funds to trade at 10% or even 15% below their net asset value. It might not sound like a lot, but that kind of discount may give you a built-in edge on the market. Not only could you gain if the fund’s holdings rise in value, you may also benefit if the discount to net asset value has decreased and you decide to sell your shares.
How to buy closed-end funds
You can buy these funds through a brokerage account. (We have a list of the best brokers for mutual funds.) You’ll want to consider:
What kind of fund do you want? U.S-only stocks? Dividend stocks? International stocks?
What is the performance over time? You can find long-term fund performance at most financial websites. Keep in mind that past performance doesn’t guarantee future results.
What is the fund’s typical discount to net asset value and its current discount? This provides you with an idea of how much the discount might decrease.
What is the fund’s expense ratio? This ratio will usually be higher than the expense ratio of an open-end fund, so beware of sticker shock.
What kind of dividend does the fund pay?
How much leverage (debt) has the fund taken on? Too much debt makes the fund riskier. Debt that is greater than 30% to 40% of the fund’s assets really amps up risk.
To gain some context when you find funds that look interesting, you’ll want to check each of these areas before making a decision on which to buy.
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Article initially appeared on nerdwallet.com
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