Closed-End Funds (CEF)

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 shares are traded on an open exchange.  Unlike open-end mutual funds, money is raised only once during an Initial Public Offering (IPO).

In the United States, a closed-end fund, or CEF, is also referred to as a closed-end company.  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 shares in the fund usually remains fixed.  Investors that want to purchase shares can buy them from another investor, a broker, or a market maker.  These are some of the distinguishing characteristics of a closed-end fund.

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 the fund is determined by the market.  This value may be greater, or less, than the share's Net Asset Value (NAV).  When buying a closed-end fund that is selling below its NAV, there is a greater chance of realizing a profit in the future, when they might be trading at or above their NAV.

Advantages and Disadvantages of Closed-End Funds

Since a CEF always has a fixed number of shares outstanding, portfolio managers can remain fully invested in securities, 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 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 securities, which includes 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, which is calculated by deducting total assets from total liabilities, and dividing this result by the number of shares outstanding.  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.

The funds are also allowed to use capital to maintain dividend payments, which means it can sell securities to pay dividends.  A fund in this situation will eventually need to cut its dividend.  When that occurs, the price may drop dramatically before investors have a chance to sell their shares.

Closed-End Fund Fees

Investors also need to be on the watch for fees that can eat into their 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.  All of the ongoing fees can be determined 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 one 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 team will be in charge of making investments on behalf of the 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, which will prescribe exactly what types of securities can be purchased.

This last point is a very important one.  For example, the charter of the fund determines if it will invest in bonds, stocks, or combinations of the two.

Buying Shares

If an investor wishes to buy shares of a closed-end fund after the IPO, they may do so on a secondary market.  The most active markets for closed-end funds in the United States are found on the NYSE EuroNext.

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

One of the more interesting aspects of these investments 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.

Funds Selling at a Premium

Normally, an investor would expect a fund to 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.  For example, a fund delivering above-average market returns might sell at a premium to NAV.  When buying a fund selling at a premium, the investor is said to be speculating.

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.

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 this symbol.


About the Author - Closed End Funds (CEF) (Last Reviewed on June 1, 2016)