Investing in Closed End Funds
There are two common variations of the popular
mutual fund; closed end and open end funds. Here's
a look at closed end funds.
A closed-end (mutual) fund is an investment vehicle that is easily compared to an open-end mutual fund,
a common investment product that most investors are familiar with.
Closed-End vs. Open-End Funds
When most investors mention a mutual fund, they’re referring to an open-ended mutual fund, a type of
investment you can buy and sell on a daily basis directly from the fund company issuing the fund. The
price of the open-ended mutual fund is based on the net asset value (NAV) of the fund. Net asset value is
the price per share.
Closed end funds on the other hand are sold directly from the company once in what's called an initial
public offering (IPO). Only a limited number of shares of the closed end fund are sold via the IPO. Shares
of these closed end funds can be bought and sold after the IPO, but only on the secondary market from
an investor who’s already purchased the shares. Because closed end funds can’t be sold back to the
company who issued the fund, they must be sold via a stock exchange.
Unlike an open end fund, the price of a closed end fund isn’t equal to the NAV. Rather, the price of a
closed end fund is sold at a premium or discount dictated by the open markets. Buyers tend to have
more negotiating power on the price of closed end funds.
Investors can make money from closed end funds by purchasing them at a discount and selling them for
a higher price. In fact, closed end funds often trade up to 20% below their actual value due to market
volatility. However, it’s not typical for the price of funds to ever rise to their NAV.
The benefit of a closed end fund is that investors are able to get the benefits of a mutual fund –
professional management and diversification – but at a lower expense than an open end mutual fund.
Closed end funds have less operating and marketing expenses than their open ended counterparts
since they trade openly on an exchange, much like a common stock.
Bond Funds vs. Equity Funds
Closed-end funds are often classified as bond funds or
Bond funds invest in bonds and debt instruments. Bonds
are like an IOU to an entity like the government or federal
agency. Bond funds might be invested in several
different types of bonds – government bonds, corporate
bonds, municipal bonds, etc.
Equity funds are invested in stocks, which are essentially
a partial claim of ownership in a corporation or its
Diversified vs. Non-Diversified
Diversified closed-end funds are invested in several different types of securities. Therefore, they are
generally less risky and more stable than their non-diversified counterparts. Non-diversified closed-end
funds are only invested in one type of security. You can find out whether a fund is diversified or non-
diversified by reading the prospectus.
Buying a Closed-End Fund
It’s typically better to purchase closed end funds a few weeks to a few months after the IPO. If you
purchase the funds on the day of the IPO, you’ll end up paying a higher price for the funds. You’ll also be
subject to sales commission. Waiting to purchase the fund on the secondary market lets you purchase
shares at a discount rather than at the full NAV.
When you decide to purchase funds, make sure you buy at a discount. That means you’re paying less for
the fund than it’s worth. Buying at a premium (a higher price) is like paying $1.25 for $1.00 – it doesn’t
Consider the fund’s expense ratio – the cost to operate the fund. Look for funds that have an expense
ratio that’s equal to or lower than other funds in the same category.
Look at how the fund has performed in the past. Past performance doesn’t always mean future
performance, but it’s still something you should consider when you’re purchasing any investment,
including closed-end funds.
Make sure you read the prospectus of the fund before you purchase. The Securities and Exchange
Commission (SEC) requires that this document be made available to all potential investors.
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