The vast array of financial products can seem confusing at first glance. Closed-end mutual funds are one such product you may have encountered. These funds offer unique features and benefits that can help enhance your portfolio and increase your diversification.
Keep reading to learn more about this investment product and how it can help you achieve your goals.
What Are Mutual Funds?
A mutual fund is a pool of money from many investors. The fund is invested in a portfolio of stocks, bonds or other assets. A professional fund manager manages the fund and determines which securities to buy and sell based on the fund's investment objectives and strategies. The investors in the fund share the profits or losses of the fund proportionally to their investment amount.
Mutual funds come in two types: open-end and closed-end. The difference between them lies in how they issue and redeem their shares.
Open-end mutual funds issue new shares to investors who want to buy and redeem existing shares from investors who wish to sell them. The price of each share depends on the net asset value (NAV) of the fund, calculated by dividing the fund asset's total value by the number of shares outstanding. These funds are also known as mutual funds or unit trusts.
Closed-end mutual funds allocate a fixed number of shares during the initial public offering (IPO) and do not offer any more shares afterward. These funds trade on stock exchanges similar to regular stocks and their price varies based on the supply and demand of the market. The price of each share may be higher or lower than the fund's NAV, which depends on the market sentiment and fund performance. Closed-end funds are sometimes referred to as closed-end companies or investment trusts.
How Do Closed-End Mutual Funds Work?
Closed-end mutual funds have distinctive characteristics that distinguish them from open-end mutual funds.
Fixed Number of Shares
Closed-end funds have a specified number of shares outstanding since they do not issue or redeem any more shares after their IPO. As a result, they are unaffected by inflows and outflows of cash from investors, which can impact their portfolio management and performance.
Trading on Stock Exchanges
Closed-end funds trade like regular stocks on exchanges and are thus subject to market fluctuations and volatility. Unlike open-end funds that can only be bought or sold at the end of the day based on their NAV, closed-end funds can be purchased or sold at any time during trading hours. This added flexibility and convenience in trading makes closed-end funds appealing to investors.
Limited Redemption Options
Closed-end funds differ from open-end funds in that they do not allow investors to redeem their shares based on their NAV at any time. Instead, investors must sell their shares on the stock market, which may result in a discount or premium to their NAV. Investors may not be able to recover the current fair value of their investment if supply and demand dynamics change the market price.
Investment Strategies Employed by Closed-End Funds
Closed-end funds often use more aggressive or specialized investment strategies than open-end funds. These strategies include leveraging, short selling, hedging, arbitrage or investing in niche sectors or markets. While these strategies may enhance returns or reduce risks, they can also increase costs or losses if they don't work as intended. As a result, closed-end funds are sometimes more complex and risky than open-end funds.
Advantages of Closed-End Mutual Funds
Closed-end mutual funds offer advantages over open-end funds for some investors.
- Potential for higher returns: Closed-end funds often have a lower cash requirement and invest a higher percentage of the portfolio, which could potentially offer higher returns compared to open-end funds that need to hold cash to meet redemptions. To boost returns or reduce risk, closed-end funds may also utilize strategies such as leverage, short selling, hedging or arbitrage.
- Trading at a discount or premium: Closed-end funds are similar to regular stocks as they trade on stock exchanges. Depending on market conditions and sentiment, their price may differ from their NAV. This price difference allows investors to buy closed-end funds at a discount or sell them at a premium. Buying at a discount can increase the yield or return of the fund while selling at a premium can lock in the profit or gain of the fund.
- Enhanced portfolio diversification: Closed-end funds offer more diversification and exposure to investors seeking to diversify their portfolios or invest in specific themes or trends. They can invest in securities, sectors or markets that may not be available or accessible to open-end funds. Also, closed-end funds can reduce the correlation or dependence of their performance on the broader market or economy. As a result, they are capable of lowering the overall risk or volatility of the portfolio.
Disadvantages of Closed-End Mutual Funds
Closed-end mutual funds also have some drawbacks that may deter some investors:
- Limited liquidity: Closed-end funds are traded on stock exchanges like regular stocks. The liquidity of these funds depends on the market demand and supply of their shares. If there are not enough buyers or sellers for their shares, their prices may fluctuate widely or become stagnant. This situation can make it difficult for investors to buy or sell their shares at their desired price or time, especially if they own many shares or if the fund is thinly traded or unpopular.
- Potential for higher expenses: Closed-end funds have more flexibility to use various strategies such as leverage, short selling, hedging and arbitrage to enhance their returns or mitigate risks. However, these strategies can lead to higher expenses, including interest costs, borrowing fees, transaction costs, management fees and other charges. These costs can reduce the fund's returns or increase its losses. Therefore, compare the expense ratio of closed-end funds with that of open-end funds before investing.
- Unpredictable market discounts/premiums: Closed-end funds are traded on stock exchanges like regular stocks. Therefore, their price may deviate from their NAV based on market conditions and sentiment. This divergence creates a risk for investors that they may buy closed-end funds at a premium or sell them at a discount. Buying at a premium can reduce the yield or return of the fund while selling at a discount can erode the capital or value of the fund. The market discounts/premiums of closed-end funds are unpredictable and may persist for a long time.
Things to Consider When Investing in Closed-End Mutual Funds
Before investing in closed-end mutual funds, investors should consider factors that can affect their performance and suitability.
Analyzing the Fund's Investment Objectives
Investors should know the fund's investment goals and strategies and ensure they match their investment objectives and risk tolerance. They should also review the fund's prospectus and annual report to learn more about its performance and operations.
Assessing the Fund Manager's Track Record
They should examine the portfolio manager's track record and reputation. This review includes their performance in various market conditions and cycles, as well as their tenure, experience, credentials, compensation and incentives.
Evaluating the Fund's Expense Ratio
Investors should compare the expense ratio of the closed-end fund they are considering with similar funds or benchmarks to help them understand how much the expenses impact their net returns or losses. They should also examine the expense breakdown to identify what they are paying for.
Understanding the Fund's Trading History
Investors should examine its trading history, trading volume and the impact on its liquidity and price movements. They should analyze the fund's historical discounts and premiums and observe how they fluctuate across different market conditions and over time.
Smart Investing with Closed-End Mutual Funds
Closed-end mutual funds offer distinct features and benefits compared to other mutual funds. However, they also come with risks and drawbacks that investors must consider. To achieve investment objectives, investors should consider essential factors and conduct thorough research before investing in closed-end mutual funds.
Frequently Asked Questions
Are ETFs closed-end mutual funds?
No, exchange-traded funds (ETFs) are not closed-end mutual funds. They are different investment vehicles with distinct characteristics.
Are closed-end mutual funds taxed?
Yes, closed-end mutual funds are subject to taxation. Investors may be liable for capital gains taxes when selling their shares and may receive taxable distributions from the fund.
Are closed-end mutual funds the same as limited partnerships?
No, closed-end mutual funds and limited partnerships are different investment vehicles with distinct structures and legal frameworks. Closed-end mutual funds are organized as corporations, while limited partnerships have a different legal structure.
About Anna Yen
Anna Yen, CFA is an investment writer with over two decades of professional finance and writing experience in roles within JPMorgan and UBS derivatives, asset management, crypto, and Family Money Map. She specializes in writing about investment topics ranging from traditional asset classes and derivatives to alternatives like cryptocurrency and real estate. Her work has been published on sites like Quicken and the crypto exchange Bybit.