Closed-End Mutual Funds: Understand How They Work
Closed-end mutual funds
Have existed longer than open-end mutual funds, but are still much less common than open-end funds. Closed-end funds share certain similarities with open-end funds but have some distinct differences, as well. Like open-end funds, closed-end funds are “managed” funds which allow investors to pool their money together to purchase a professionally managed portfolio of investments, including stocks and bonds.
Open-end funds are bought and sold through the mutual fund company, with no limit to the number of available shares. Closed-end funds, however, are launched through an initial public offering (IPO) that operates by raising a specific amount of money through issuing a specific number of available shares. The proceeds are then invested, and the closed-end fund is configured into a stock listed and traded on a secondary market such as the New York Stock Exchange. The fund’s investment portfolio is usually managed by an investment advisor, registered as a separate entity with the Securities and Exchange Commission.
In some ways, closed-end funds have more in common with stocks or exchange-traded funds than they have in common with open-end mutual funds. Because the shares are bought and sold on the open market, investor activity has no significant bearing on decisions about handling the funds. The value of the funds’ shares fluctuates with market conditions, resulting in shares being worth more or less than their original cost.
Closed-end funds start with a net asset value (NAV), but after the IPO, the market price on the secondary market is determined by supply and demand, instead of NAV. This results in shares selling at a “premium” if the new price is higher than the original price or a “discount” if the new price is lower than the original price. At the close of business, an open-end mutual fund is redeemed back to the mutual fund, but a closed-end fund must be redeemed by way of the open market: a buyer must be found, incurring commission fees.
Closed-end funds can be a valuable investing tool, but the benefits and risks involved should be understood. Closed-end funds are attractive to some investors because they are designed to provide a steady stream of income on a more regular basis than individual bonds usually provide. However, closed-end funds are thought to be riskier, more volatile, and less liquid than open-end funds. Closed-end funds can include a greater number of securities which cannot quickly and easily be converted into cash, and leveraging methods are different from the methods used by open-end funds. The investment company does not have to buy back shares to meet investor demand, and shares sometimes languish. Closed-end funds also have broker trading fees and annual management charges that vary between 1% and 2%.
Mutual funds and exchange-traded funds are sold only by prospectus. Please consider the investment objectives, risks, charges, and expenses before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.