Are you overlooking closed-end funds?
Many investors own mutual funds and are therefore familiar with their ways of working. One fact often missed, however, is that a majority of mutual funds are open-end funds that don’t restrict the number of shares. Rather, they issue and redeem them in response to moving demand from investors.
Understanding the distinction between open and closed end funds offers an opportunity for diversified investments. As 2011 came to a close there were 7,637 open-end mutual funds in the United States, as compared to just 634 closed-end funds.
Clearly this is an area worthy of closer examination, to see what potential could be on offer for informed investors.
Limitations of Closed End Funds
A closed-end fund issues a fixed number of shares in an initial public offering (IPO - read more here), with fund managers using the proceeds to take on investments that reflect the fund’s stated objectives. The fund is then listed on an exchange and traded on the secondary market, similar to a stock, and transactions typically incur a brokerage commission. Although a fund may issue additional shares in a subsequent offering, this is uncommon. Shares tend not to be repurchased or redeemed by the fund.
The price of a closed-end fund can change throughout the trading day, like a stock, as a result of fluctuating supply and demand. Depending on the market, the price could be higher or lower than the net asset value (NAV) of the underlying investments. When this occurs, the fund is said to be trading at a premium or discount, respectively. By contrast, open-end mutual funds are generally priced once daily at the end of the trading day, and the price is based directly on the NAV.
More Flexible, Less Liquid, More Risk
Closed-end funds may hold stocks, bonds, and other types of underlying investments. Unlike open-end funds, closed-end funds do not need to maintain cash reserves or sell securities to meet redemptions. For this reason, the fund has the flexibility to invest in less liquid securities. Closed-end funds also may borrow against their assets, subject to certain limitations, allowing them to use leverage as an element of their investment strategy. This can make the funds more volatile and involves additional investment risk.
Both open-end funds and closed-end funds are professionally managed and charge management and other fees. The return and principal value of all mutual funds fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost.
Closed-end funds are relatively sophisticated investment vehicles and may not be appropriate for everyone. If you have an interes in adding one to your portfolio, be sure you fully understand the fund’s objectives and underlying investments before taking the plunge.