Investing 101: Closed-End Funds

Investing Advice

Mutual funds have been popular for many decades. The traditional fund is “open-ended,” which means there is no limit on the level of capital or number of investors in the fund.

As a result, many funds have grown into the mega-millions of dollars and cannot move quickly in and out of positions. Often, this means that their returns may suffer. Some funds may still out-perform the overall markets, but others will under-perform. There are many possible reasons for a disappointing return, one of which is the sheer size of assets these funds manage.

For some investors, an alternative solution is investing in a closed-end fund: a type of mutual fund that sets a limit on how large a portfolio it will manage.

One of the biggest distinctions between open-end and close-end funds is how they’re managed.  Because closed-end funds can only take on a limited amount of money, one could argue that asset management is, in fact, easier than that of an open-end fund.

Open-end funds, for example, are forced to over-diversify because of regulatory limitations on how much any fund can invest in a signle company. Closed-end funds have greater flexibility in that regard.

Another distinction is how closed-end funds are traded. You can purchase shares of an open-end fund directly from the fund family or from a broker, while closed-end funds are traded on public exchanges, just like stocks and ETFs. This does not guarantee better returns, but the structure of a closed-end fund changes the supply and demand for shares.

Public exchange trading creates greater flexibility in buying and selling shares, but an even more interesting possibility is that the net asset value (NAV) of a closed-end fund can actually exceed the total value of funds under management. This occurs when the public demands more shares than current owners are willing to sell.

On the flip side, an under-performing closed-end fund can also fall to a value lower than its portfolio net asset value.

The big difference here is in how valuation changes. An open-ended fund has no supply and demand attribute because management places no limit on how much it will manage. So a portfolio can continue to grow as more capital moves into the fund.

Does this mean a closed-end fund is a better investment? Not necessarily.

Closed-end funds are appealing because the limited number of shares creates market-based supply and demand. However, they also have little or no cash on hand, reducing their flexibility. With no new money coming into the fund, management has to make do with its self-imposed cash limits. The potential for discounted value (as well as the opportunity for a premium) makes the closed-end alternative an entirely different form of fund than the better-known open-end variety.

The biggest advantage of closed-end funds is trading flexibility for investors. You can buy and sell shares on the exchange just like shares of stock.

The limited size of assets under management also means the closed-end fund will not grow into a massive multi-billion dollar portfolio like many of the largest funds today. Success by these big open-end funds in attracting investors, ironically, also limits their flexibility. With a closed-end fund, you know that the size of assets under management will not increase. Valuation is not only a matter of management’s ability to pick investments, but also of supply and demand.

Michael C. Thomsett is author of over 60 books, including Winning with Stocks and Annual Reports 101 (both published by Amacom Books), and Getting Started in Stock Investing and Trading (John Wiley and Sons, scheduled for release in Fall, 2010). He lives in Nashville, Tennessee and writes fulltime.

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