Closed End Funds 101

stock marketAs a follow up to my last post on mutual funds, this one will focus on another breed of investment funds — the closed end fund as suggested by a reader.

The name closed end fund may suggest simply a slight variation of what we normally think of as a mutual fund. But in reality, a closed end fund is completely different. Like a mutual fund, a closed end fund invests for a defined objective, whether it be a particular stock strategy, an income strategy, or even a mix of stocks and bonds. However, it acts more like a stock when it comes to investing in one. When a closed end fund is created, it is sold via an IPO (initial public offering), just like a stock. There are a fixed number of shares available, and then the fund closes to new investors.

After that, shares of the fund sell on the secondary market, which means to buy, you are in essence buying existing shares from someone else, and vice versa if you want to sell.

On the other hand, with an open ended mutual fund, the money you use to buy shares actually goes into the fund and gets invested. When you sell your shares, the cash you receive comes out of the fund, or investments are liquidated to raise cash if there is not enough available (as in a day when many investors sell off) So a mutual fund may need to keep an amount of cash uninvested to satisfy redemptions (sales) when they come in. Closed end funds are not concerned with that, so there will be less idle cash in the fund.

Mutual funds are priced once a day, after trading closes, so the price, or net asset value, will be established based on the closing price of all of the stocks or bonds that comprise it. That is when the orders to buy and sell are executed.

Closed end funds, like shares of stock, trade all day long, the share price fluctuating throughout the day. The price is determined by the market value of the share itself, not by the value of the underlying stocks or bonds. What that means is, what you pay for a share of a closed end fund will not be equal to the NAV of the fund itself, and rather will trade at a premium (the price per share is higher than the value of the investments inside of it) or at a discount (price per share is lower).

Naturally, a closed end fund trading at a discount is good for a buyer. It is not so great for someone who purchased in the IPO. That buyer likely paid a premium to get in due to the costs associated with IPOs (such as offering expenses and broker commissions).

Some closed end funds are designed to pay out a distribution quarterly or annually. For investors seeking a regular source of income, that can be appealing. In a mutual fund, dividends and capital gains are paid out regularly, too, but they will differ from quarter to quarter, based on what the underlying investments are actually earning. The closed end fund may instead choose to distribute a flat percentage for predictability of income.

That means, though, that if in a certain quarter the actual income is less than the percentage promised, part of the distribution may be paid out of principal, or really, a return of your investment. So in some cases that distribution rate may be deceiving. That’s not necessarily a bad thing, but if you have a fund that does that on a regular basis, it can actually affect the net asset value of the fund.

Just like a mutual fund, a closed end fund has operating costs. They vary widely from fund to fund, so it’s important to know what those costs are, because over time, those costs will eat away at your return. There will also be a cost to purchasing the fund. You’ll want to evaluate those costs against any potential greater return.

An important note about that potential greater return: A closed end fund may use leverage (borrowing) to acquire additional capital to make investments. Leverage increases the risk of the fund. Remember, there’s no free lunch, so if you are getting significantly more income than you can find elsewhere, you can bet there is an accompanying increase in risk.

Closed end funds may be appropriate for you — or not. As with any investment, you must do your due diligence on the fund before investing. With a closed end fund, you may find the answers to questions about fund composition, expenses, leverage, pricing and distributions from the company itself, and also from the prospectus and other filed reports in the Securities and Exchange Commission’s EDGAR (electronic data gathering, analysis, and retrieval) database at sec.gov/edgar/searchedgar/webusers.htm.

Exchange traded funds are yet another, more common, breed of investment vehicles that I will tackle in another post soon.

photo by: 401(K) 2013

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