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 investing in closed end funds.

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A closed-end (mutual) fund is an investment vehicle that iseasily 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 equity funds.

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 earnings.

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 make sense.

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.