Closed End Funds

A closed-end fund, also known as a closed-end company, is one of three basic types of investment companies. A closed-end fund works like an individual stock because the fund's shares are traded on an open exchange.  Unlike open-end mutual funds, closed-end mutual funds raise money only once during an Initial Public Offering (IPO).

Closed-End Funds Defined

In the United States, closed-end funds, or CEF, are also referred to as closed-end companies.  In the United Kingdom, they are called Unit Investment Trusts; while in Australia they go by the name Listed Investment Companies.

Once issued, the number of fund shares usually remains fixed.  Investors that want to purchase shares in a closed-end fund can do so by buying shares from another investor, a broker, or a market maker.  These are some of the distinguishing characteristics of a closed-end fund.  For example, open-end funds are normally purchased from a mutual fund company, and new shares are constantly created and / or removed.

IPOs and Closed-End Fund NAV

As is the case with other public companies, a closed-end fund has a board of directors.  This board is responsible for appointing an investment advisor and portfolio manager, which will make the actual investment decisions.

After the IPO, the price of a closed-end fund is determined by the market.  This value may be greater, or less, than the share's Net Asset Value (NAV).  When you buy a closed-end fund that is selling below its NAV, you increase your chances of realizing a profit by selling shares at a later date, when they might be trading at or above their NAV.  Before we get too far down that road, let's take a look at the advantages and disadvantages of closed-end funds.

Advantages and Disadvantages of Closed-End Funds

Since a CEF always has a fixed number of shares outstanding, the portfolio managers can keep all of the funds invested, and not worry about keeping cash on hand to pay investors seeking to redeem shares.  They also pay dividends in much the same way as other exchange-traded stocks.

Because mutual funds also have liquidity requirements, they are not allowed to invest in certain securities.  Closed-end funds do not have this restriction; therefore they can invest a greater proportion of funds in illiquid securities; ones that can't be sold within seven days.  This feature allows closed-end funds to invest in a wider array of stock exchanges, and therefore opens up the door to investments in emerging markets, global, regional, or even single countries.

As previously mentioned, a closed-end fund is quoted in terms of its net asset value or NAV.  By deducting total assets from total liabilities, and dividing this result by the number of shares outstanding, you can calculate the NAV for a fund.  Since the fund is publicly traded, it is susceptible to the same demand and supply fluctuations that occur in the stock market.  That's great when the market is soaring, but bad news during stock market slumps.

One additional item that you also need to be aware of when looking at closed-end funds is the funds are allowed to use capital to maintain dividend payments.  This is true even when the fund is not earning enough money to cover the dividend expense.  If a fund is in this situation, then it will eventually need to cut the dividend.  When that occurs, the price of the fund may drop dramatically before investors have a chance to sell their shares in the fund.

Closed-End Fund Fees

Investors also need to watch out for fees that can eat into fund returns.  Since closed-end funds are traded just like common stocks, shares are purchased through a broker.  It's important to understand the sales fees and management expenses of the fund before making a purchase.  You can determine all of the ongoing fees by taking a close look at the fund's prospectus..

Investing in Closed-End Funds

The process of creating a closed-end fund, and investing in a closed-end fund during its IPO, can be broken down into three steps:

1. Sponsorship - Just like open-end funds, a closed-end fun is normally sponsored by a management company.  The fund's management company will be in charge of actually making the investments on behalf of the fund owners.
2. Solicitation of Money - Next, the sponsoring fund management company will begin soliciting money from investors.  They can make this initial offering open to the public, or limit the offering.  Each investor is given a number of shares that are in proportion to their contribution and the total money collected.
3. Purchase of Fund Securities - In the final IPO step, the money collected from all investors is used to purchase securities on the open market.  Each closed-end fund normally operates under the guidance of a charter.  The charter will prescribe exactly what types of securities or investments can be purchased for each fund.

This last point is very important for anyone looking to invest in a closed-end fund.  For example, the charter of the fund determines if the fund will be a bond fund, invest in stocks, or combinations of these investments are allowed.

Buying Shares in a Closed-End Fund

If an investor wishes to buy shares of a closed-end fund after the fund's IPO has taken place, they may do so on a secondary market.  The most active markets for closed-end funds in the United States are the New York Stock Exchange and the American Stock Exchange.

Limit and Stop Orders

Most open-end funds, including mutual funds, are purchased and sold at the close of each trading day after the NAV is calculated.  All orders must be placed in advance of the next trading day.  Exchange-traded closed-end funds are traded continuously, and are eligible for advanced market orders such as limit and stop orders.

Premiums and Discounts on Closed-End Funds

One of the more interesting aspects of closed-end funds is the fact they often sell at a discount, or premium, to the net asset value.  To many investors this concept can be quite confusing, and even seem irrational.

Closed-End Funds Selling at a Premium

Normally we'd expect that a fund would sell at a price per share that was aligned with the value of the underlying securities.  But for some reason, a closed-end fund might be selling at a premium to the value of the fund's investments.  When a fund is in this situation, it is said to be selling at a premium to NAV.

The explanation for why some closed-end funds sell at a premium may have to do with future expectations of investors.  For example, a fund delivering above-average market returns might sell at a premium to NAV.  When buying a closed-end fund selling at a premium, the investor is said to be speculating.

Closed-End Funds Selling at a Discount

On the other hand, funds can also sell at a price per share that is less than the value of the underlying securities.  When a fund is in this situation, it is said to be selling at a discount to NAV.

A CEF might sell at a discount if investors are losing faith in the fund's managers.  In theory, a closed-end fund selling at a discount might look like a good arbitrage candidate.  For example, all shares of the fund could be purchase at a discount, and the underlying securities sold for profit at actual market value.

Closed-End Fund Quotes

All closed-end funds, just like mutual funds, are assigned a stock ticker symbol.  That means an investor can easily find a closed-end fund quote by going to the exchange on which it trades and looking up the CEF's ticker symbol.

You can also find CEF quotes through any of the major financial information providers including Google Finance, Yahoo! Finance, and Microsoft Money.

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