1. What's a Closed-End Fund?
There are two types of mutual funds -open-end funds and closed-end funds. Imagine they're twins who share the same DNA but go through life doing things very differently.
Both fund types sell shares to investors and use the cash that's invested to buy securities that match their investment missions. But that's where the similarities end.
You may have also heard a lot about exchange-traded funds. These newly popular function similarly but they're not "mutual funds," as you'll soon see. When people say "mutual funds" they're usually referring to open-end funds. These guys can sell an unlimited number of shares to investors. The price per share-also known as the net asset value (NAV)-is calculated by dividing the market value of the fund's assets by the number of shares held by investors.
So-if a fund has net assets of $100 million and there are 5 million fund shares in the hands of investors, the fund's share price would be $20. That's why open-end mutual funds trade only at the end of each day, when trading stops and the final price can be calculated.
Most people own the open-end variety in their retirement and taxable accounts.
Now let's look at the lesser-known twin-closed-end funds. These funds issue a set number of shares that trade on the stock exchange throughout the day. The value of these shares is based on demand. If lots of investors buy shares, the price goes up. If lots of investors dump them, the price goes down.
What if a closed-end fund's share price is lower than the fund's net asset value? Meaning, what if the price tag on a bag of coins is less than the value of the coins inside? You'd get a discount on your investment.
The same is true for closed-end funds. If you invest in a fund with a share price that's lower than its NAV, congratulations, you're getting a discount. If the gap between that fund's share price and its NAV narrows after you invest, you'll receive a bonus when you sell shares. Just as if the price of that bag of coins went up when you sold it.
But don't get too worked up. Most closed-end funds offer a discount. The key is how much of a discount they're offering and whether you think the fund will perform well over time. If it does, and the discount shrinks after you've purchased shares then you earn a profit.
Like open-end funds, closed-end funds come in dozens of types ranging from U.S. stock and bond funds to funds that invest in a singe country or region. But don't confuse a closed-end fund with a "closed fund." A closed fund is an open-end fund that no longer accepts new investors.
Closed-end funds tend to be actively managed-meaning the manager of the fund buys and sells securities often in an effort to outperform the fund's benchmark index. The result may be higher fees and increased taxes, if you hold the fund in a taxable account.
2. Should You Invest in a Closed-End Fund?
To make this simple, think of an ETF as the cool cousin of the closed-end fund. ETF shares trade on the stock exchange-just like closed-end funds. But ETFs generally track a market index, making them more efficient than closed-end funds and a lot easier to understand. Most ETFs also charge lower fees and are more tax-efficient because the securities in their index-based portfolios aren't often traded.
All that said, closed-end funds do have a few benefits:
Bottom line: Unless you're willing to roll up your sleeves and research closed-end funds and their discounts, you may be better off in a similar open-end fund or ETF.
3. How to Invest in a Closed-End Fund
Still want to invest in a closed-end fund? Follow these steps to size up a fund and get the best deal:
You can generally assume that the fund's discount eventually will migrate back to its historical average. For example, if a fund's historical average discount is -7% but it is now trading at a -12% discount, you can expect the fund will return to its historical 7% average-and you'll wind up pocketing the difference.
4. Grilling Guide: Questions to Ask a Closed-End Fund Manager
How has the fund performed?
See how the closed-end fund has performed over the past five years or longer compared with its benchmark index-and an equivalent open-end fund.
What's the discount gap?
What's the fund's historical one-year average discount and what's its current discount? Consider funds that are more deeply discounted now than its historical average.
What's the expense ratio?
Your returns will be based not only on performance and the discount but also how much of those returns must be shelled out for expenses and fees. Compare the average closed-end fund expense ratio with average ratios of open-end funds and exchange-traded funds investing in the same asset classes.
How often are distributions paid?
A closed-end fund typically makes distributions monthly or quarterly. See if you can choose to have them reinvested to maximize compounding and returns.
What about volatility?
Think of volatility as mood swings. If these swings are severe compared to the market norm, you could be facing greater risk. Why? Because while the value of your investment may be way up when markets climb, it could just as easily be way down when markets face decline or uncertainty. Steep drops could be especially bad for you if they occur just when you need to sell your investment.
An investment's volatility is measured by something called "beta." Closed-end funds that have a beta greater than 1 have greater price volatility than the overall market and are more risky. The same is true for individual stocks. Of course, greater risk also means a shot at higher-than-average returns when you need to sell.
Do you know about common mutual fund disadvantages? While mutual funds can work out well for investors, they can have a down side if you don't do your homework.