Closed-end funds may not be something you’ve heard mentioned often. Your investment portfolio is more likely to include open-end funds, mutual funds or exchange-traded funds (ETFs) instead. However, closed-end funds can offer some advantages for investors. This guide explains what they are, how they work and how to invest in them.
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What Is a Closed-End Fund?
To understand what a closed-end fund is, it first helps to know a little about open-end funds. An open-end fund is the kind of mutual fund you may invest in through your 401(k) or individual retirement account. These funds have an unlimited number of shares to buy and sell. Prices are set once a day at the end of trading.
Closed-end funds are funds that have a set number of shares to trade. When investors buy or sell shares, no new shares are issued. A closed-end fund is the result of an IPO or initial public offering. Companies launch closed-end funds when going public to raise capital.
A closed-end fund trades on an exchange like a stock. Shares can be bought and sold throughout the day. Prices for fund shares can rise or fall, based on supply and demand for the fund. A professional fund manager oversees activity for the fund, which includes deciding which underlying assets to buy or sell.
These funds are called closed-end because cash doesn’t flow freely in or out the way it would with an open-end fund. Closed-end funds can pay dividends to investors on a monthly, quarterly or annual basis. These dividends are generally considered taxable income for investors. The the exception is a closed-end municipal bond fund. Municipal bonds are tax-exempt.
Benefits of Investing in Closed-End Funds
There are several reasons closed-end funds might appeal to investors. The first is diversification.
Closed-end funds can help you diversify your portfolio by adding exposure to different asset classes or sectors. For example, you may invest in a fund that’s focused on small-cap U.S. stocks or international stocks. You can use these funds to fill in gaps in your portfolio or to balance out areas where you may be over-weighted.
A closed-end fund can offer flexibility since you can buy or sell shares throughout the trading day. This is helpful if you’re trying to leverage price movements, whereas the price for open-end funds is set once per day at closing.
Another significant benefit is the potential to earn higher returns from these funds. This ties into understanding how fund shares are valued. The typical fund’s pricing is tied to something called Net Asset Value (NAV). This measures the market value of a fund’s assets, minus its liabilities and then divided by the number of shares outstanding.
With closed-end funds, the aim is to buy shares at a discount to NAV. This means that you’re getting the fund at a price that’s below the NAV. If you can buy shares at a discount, then sell them later at a higher price, the result is a gain on your investment. The opposite of this is buying shares at a premium, or at a price above NAV.
This kind of fund can also be less expensive because the turnover ratio is lower. The turnover ratio is how often assets are traded in or out of the fund. Expense ratios, or the cost of owning the fund each year, may also be lower compared to some open-end funds.
Closed-End Fund Drawbacks
The risks associated with this type of fund mainly include market risk and how that can affect pricing. If stocks experience a bout of volatility, then that can cause fund prices to fluctuate as well. Interest-rate risk is also something to watch out for if the fund includes a large number of bond holdings. Bond yields correlate to rate movements so it’s important to understand the type of bonds in the fund, their maturity terms and how they may react to rising or falling rates.
Additionally, you also have to be aware of how price changes and shifts in the fund’s NAV can affect your profit potential. Specifically, buying shares at a premium to NAV could be risky. If the fund’s price declines further, you may have to sell at a loss.
Leverage is something else to keep in mind. If a closed-end fund is taking on debt to purchase securities, the upside is that your dividend yield on shares may increase. The downside is that if the cost of the fund’s debt increases because interest rates rise, share prices could become more volatile. This could make you more susceptible to losing money on your investment if share prices fall or if the company sells off assets to pay off some of its debt.
How to Invest in Closed-End Funds
The first step to investing in these funds is opening a brokerage account if you don’t have one already. Consider opting for an online brokerage, since they may offer more favorable pricing when charging trading commissions or fees.
The next step is deciding which funds to buy. This is where you’ll want to do your homework and research fund characteristics such as the ones listed below.
- Performance history: While past performance doesn’t guarantee future results, it can give you an idea of what a fund has returned to investors over time.
- Debt: Generally, the more debt a fund is carrying, the riskier it may be to investors.
- Fund expenses: Check the expense ratio to determine how much you’ll pay to own the fund each year. Also compare the commission fees the brokerage charges.
- Dividend yield: If a closed-end fund pays dividends, look at the dividend yield and how that’s trended over time.
- Fund manager: It’s also helpful to check out the fund manager to see what kind of track record they have, either with the fund you’re buying or other securities.
- Discount/premium: Consider where the fund’s pricing lines up with the NAV if you’re looking for an opportunity to buy at a discount.
- Allocation: Lastly, look at the underlying assets of the fund. A closed-end fund that’s heavy on bonds, for example, could pose more risk if interest rates are set to rise or fall.
Closed-end funds could help you achieve your investment goals, but it’s important to keep the risks in focus. As with any other investment, it’s important to know what you owe and how that fits with your risk profile and investing goals.
- Exchange-traded funds can offer an alternative to closed-end funds for investors who want trading flexibility. ETFs trade on an exchange like a stock. They can offer greater tax efficiency than traditional mutual funds, since they tend to have lower turnover rates. Remember to check the same metrics for an ETF as you would a closed-end fund, including expense ratio, past performance and dividend yield.
- A financial advisor can help you building an investment portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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