Don't Close Your Mind to Closed-End Funds

Written By
Paul Tracy
Updated January 16, 2021

When most investors hear the word "fund" in relation to investment vehicles, their thoughts immediately head to mutual funds. This isn't surprising since mutual funds are the option of choice for many investors seeking to gain exposure to the stock market. Mutual funds are fine investment choices, and their merits shouldn't be derided.

That being said, if holding and monitoring individual equities isn't your cup of tea but you seek exposure to equities or fixed income investments, there is another compelling option available: Closed-end funds. Closed-end funds differ from mutual funds in that there are limited opportunities to participate. These funds offer investors shares that trade like stock, with the difference being that there isn't likely to be multiple secondary offerings after the fund's initial public offering (IPO). The issued shares track the fund's performance.

While there are many mutual funds that track specific sectors or geographies, a large mutual fund, say one that manages $1 billion or more, is likely to hold dozens of stocks. A mutual fund that manages $20 billion may hold 50 or 60 or more stocks across many industries with no particular name accounting for too much of the fund's exposure. On the other hand, closed-end funds are usually more narrow. A typical Closed-end fund really zeros in on a particular sector, securities group or country and is likely to own fewer securities than a traditional mutual fund.

These are actively managed funds and the performance of the held securities determines shareholder profit and loss. Let's delve deeper into the world of closed-end funds.

Is The Price Right?

One important aspect of closed-end funds for investors to note is how their price is calculated. A traditional mutual fund's price is computed once a day and all investors buying and selling that fund on any given day pay the same price. That price is known as the net asset value (NAV).

Closed-end funds also have an NAV that is calculated at the end of the trading day, but it is not uncommon to see the share price of a closed-end fund differ from its NAV. If the shares are trading at a higher price than the fund's NAV, they trade at a premium and the fund may be overbought. Conversely, a fund with share price lower than its NAV trades at a discount. Many experts would argue that closed-end funds that trade at substantial discounts to their NAV offer compelling opportunities for investors to pick up good assets on the cheap.

Advantages over Mutual Funds

Like mutual funds, closed-end funds often tout their diversified portfolios as one of their main selling points. A closed-end isn't likely to suffer too much if one or two of its holdings are performing poorly because the intent of closed-end funds is to spread market risk.

In a declining market, a mutual fund manager may not have the ability to liquidate holdings because dumping large amounts of stock would further impact market declines. Closed-end funds, on the other hand, are usually more nimble and can build and exit positions more efficiently.

Another advantage of closed-end funds is cost. Mutual funds have expenses like management fees, loads and transaction costs. When you redeem your mutual fund shares, you'll get the NAV minus a percent or more of expenses. Since a closed-end fund trades like a stock, all you'll pay is your broker's commission.

Closed-end fund may issue debt or preferred stock to investors to raise capital. That said, investors should be leery of closed-end funds with exceptionally high dividend yields as this is often a sign of too much leverage.

One more thing sure to make investors without a lot of capital happy is that there is no minimum investment with closed-end funds. A mutual fund may require investors to pony up $2,500 or more just to get in, but because closed-end funds trade like stocks, as long as you can afford one share, you can become a part of the fund.

Not As Popular As You Might Think

Given the noticeable advantages of closed-end funds over mutual funds, one would think they'd be just as popular. Interestingly, both mutual funds and exchange traded funds (ETF) dwarf their closed-end counterparts in sheer size. There is also a common misconception that closed-end funds are reserved for elite investors. Don't let either of these misnomers keep you away from closed-end funds. Your portfolio will thank you.

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