There are many types of mutual funds, yet all of these funds can be broken into two main groups. Most of the funds out there are open end funds. These are the typical managed mutual funds and index funds you’d find in a 401k or invest in through an IRA. Logically, the other group is closed end funds. Before you invest your money you should know how these funds work.
What is a Closed End Fund?
A closed end fund is a mix between a mutual fund and a stock. A closed end fund invests in a basket of assets just like any mutual fund does, but it trades on an exchange like a stock.
Yet, it’s not like your typical mutual fund. Most mutual funds are open end funds. Open end funds allow for an unlimited number of shares. As investors add or withdraw money, the number of shares increase and decrease accordingly and the size of the fund does too.
On the other hand, closed end funds have a fixed number of shares. Those shares are first issued through an IPO and then trade on an exchange just like stocks or ETFs. Because of this, the share price is at the whim of the markets. This can present some interesting opportunities.
You see, a mutual fund’s share price is usually determined by the funds NAV (that’s Net Asset Value). Since a mutual fund is just a giant portfolio invested in different assets, the total value of those assets is known as the NAV. When you divide the total number of shares by the fund’s NAV, you get the share price.
Finding the share price is easy for open end funds. After the market closes, the fund company adds the value of every asset in the fund, get’s the total NAV, and divides by the number of shares. When you buy and sell your open end fund shares, you’ll always get the market value for those shares.
It doesn’t work that way with closed end funds. Yes, NAV is still calculated the same way. But because closed end funds trade on the open market, the share price can trade above (a premium to) or below (a discount to) the fund’s NAV.
A savvy investor would buy a closed end fund trading at a discount to NAV and try to sell at a premium.
The opportunity to buy a fund for less than it’s worth and sell it for more is just one benefit. Here’s a few more:
- No share redemptions – fund managers can invest the fund’s money without having to plan for shareholders redeeming shares.
- Leverage – fund managers can borrow money to boost returns, not all closed end funds use leverage.
- Diversification – it’s still a mutual fund invested in many assets.
Closed end funds aren’t without risks either:
- Leverage – borrowing money increases risks (and costs).
- Liquidity/Low Volume – higher liquidity risk exists for funds with low volumes.
- Costs – the expense ratios are competitive with most open end mutual funds, but still higher than index funds and ETFs. The costs for leveraged funds are complicated by interest expense.
The opportunities abound with closed end funds. The idea of buying something for 80 cents on the dollar is enticing. Remember, there’s an investor on the other end willing to sell it for 20 cents less than it’s worth. That alone should make you ask why? Make sure you understand the risks before investing in closed end funds. In the end you might be better off with an alternative open end mutual fund or ETF.