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 in number.  Investors wanting 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 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 that will make the actual investment decisions.

After the IPO, the price of a closed-end fund is determined by the market and 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.  But 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 thing that you also need to be aware of when looking at closed-end funds is that these funds are allowed to use its capital to maintain dividend payments - even when the fund is not earning enough to cover the dividend.  If a fund is in this situation, then it will eventually need to cut the dividend and the price of the fund could drop dramatically before you have a chance to sell your shares in the fund.

Closed-End Fund Fees

You also need to watch out for fees that can eat into fund returns.  Since closed-end funds are traded just like common stocks, you need to purchase shares through a broker.  You need to make sure you understand all of 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 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 / 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, it is the charter of the fund that determines if the fund will be a bond fund or invest in stocks or the combinations of investments 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 even eligible for advanced types of 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 most 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 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 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 simply going to the exchange on which it trades and looking up the CEF's ticker symbol.

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

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