Wondering About Closed-End Funds? Learn a Few Basics Before Diving In

Closed-end funds (CEFs) trade like shares of stock on exchanges, go up and down in price, and do other things investors are probably familiar with. CEFs are also a category of mutual funds. Knowing those basics, can investors jump right into the CEF pool? Not so fast.

CEFs have some unique characteristics and differ in critical ways from “open-end” mutual funds and other investment vehicles, according to Michael Fairbourn, education coach at TD Ameritrade. What is a closed-end fund and how do closed-end funds work? Let’s walk through a few key CEF questions for investors.

Closed-end funds are like shares of stock in some ways. What does that mean?

Like mutual funds in general, CEFs are pools of assets—stocks, bonds, and other investments—overseen by investment management companies. CEF managers hold initial public offerings (IPOs) to raise capital, selling a fixed number of shares (that’s what makes them “closed”) of a single CEF, and each CEF gets its own ticker symbol.

After a CEF is issued to the public, broader market supply-and-demand dynamics take effect, Fairbourn noted. Yet it’s those very dynamics that can make CEFs more volatile and trickier to navigate than some other investments.

Are closed-end funds regulated, and how many CEFs are there?

CEFs are one of three basic types of investment companies regulated by the U.S. Securities and Exchange Commission, or SEC (the other two are open-end funds and unit investment trusts). That means CEF managers, like publicly traded companies, are required to file prospectuses, shareholder reports, and other information, which investors should exhaustively study.

Closed-end funds “come in many varieties,” as stated on the SEC website. CEFs “can have different investment objectives, strategies, and investment portfolios. They also can be subject to different risks, volatility, and fees and expenses.”

At the end of 2018, there were 506 CEFs with total assets of $250 billion, according to the Investment Company Institute.

How does a closed-end fund differ from an open-end fund?

Open-end funds, also regulated by the SEC, sell shares on a continuous basis, which in theory means these funds have an unlimited number of shares.

Shares of open-end funds can be issued and redeemed over and over through a manager or broker, and at the end of every trading day, an open-end fund is “balanced” to determine its net asset value (NAV).

What is net asset value and why is it critical for mutual fund investors to understand?

NAV, the value per share of a CEF or other type of mutual fund, is calculated by taking the market value of the fund’s assets less the fund’s liabilities and dividing by the total number of outstanding shares.

For example, if a CEF holds assets worth $100 million and has liabilities of $10 million, its NAV will be $90 million. The fund’s assets and liabilities change daily with the overall markets, so NAV will also change. NAV might be $90 million one day, $100 million the next, and $80 million the day after.

Is a certain CEF a “good” or “bad” investment? Understanding NAV can help shed light on that question.

According to Fairbourn, the actual market value of individual assets in a CEF can differ from the CEF’s price. An “undervalued” CEF trading at a discount to its NAV could generate a greater return than the actual shares or other assets that comprise it. Conversely, an “overvalued” CEF, trading at a premium to its NAV, could underperform. Consider NAV (among other factors) carefully before investing in any CEF.

What are some potential advantages of closed-end funds?

CEFs have the potential for fatter dividend yields compared with individual income-bearing stocks. A basket of stocks may offer a dividend yield of, say, 3%; by contrast, a similarly constructed but undervalued CEF could, in some cases, pay 8% to 10%. Again, NAV is a critical metric, but just one of several considerations.

Also, because CEFs trade like shares of stock, investors can gain more flexibility and diversification opportunities.

For example, if the stock market was rising or falling sharply on a particular day, and investors wanted to make a move right then, they wouldn’t have to wait until end of the trading day with a CEF (as opposed to open-end counterparts). CEFs “allow for more of an ‘active’ investing or trading approach,” Fairbourn explained.

What are potential drawbacks of closed-end funds?

The benefits of CEFs can also cut the other way.

According to Fairbourn, CEFs can be more volatile than open-end funds, a consideration for investors seeking to avoid whipsawing and headline-driven markets. Some CEFs also use margin leverage, meaning the fund manager borrows money with the aim to amplify returns. Margin isn’t necessarily bad, but it does carry certain risks, and investors should think it through carefully before investing in a CEF that uses leverage.

CEFs charge management fees, as do other types of funds. Depending on the CEF, the fees may be higher than those for some other funds, particularly if the CEF is leveraged. “Be sure to study the fee structure of any CEF and see how it compares against other funds,” Fairbourn concluded.