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Definition of A Closed-End Fund
by Ben Bontekoe
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Overview
A closed-end fund is an actively managed mutual fund with a specific number of shares set by the fund management. The capital for the fund to invest is raised by selling those shares at a set price per share through an initial public offering (IPO). After the IPO, the fund company typically "closes" the fund by not issuing any more shares. Instead, the fund's shares become publicly traded, usually on a major stock exchange. That is the most obvious difference between closed-end funds and the more common open-end mutual funds. But we'll examine other differences (and some similarities) as we explore closed-end funds' characteristics.
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The Facts
The assets in a closed-end fund are actively managed, and consist of stocks, bonds, or a combination of both. Like an open-end fund, a closed-end fund can contain any type of investments in its portfolio, but most funds specialize in a specific asset class (typically stocks or bonds) and in a specific industry (such as energy or health care) or sector (such as large-cap growth stocks or high-yield corporate bonds) or geographic area (such as Latin America or China). Because closed-end funds are publicly traded, the price of shares fluctuates due to supply and demand in the market, as well as the value of the assets in the fund.
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Share price
Once all the shares are sold in the IPO, the fund manager uses the money raised to invest in the underlying assets of the fund. Although the fund will compute the underlying value per share of the assets in the fund--the net asset value (NAV)--the actual share price is determined by demand in the market. On the other hand, the share price of an open-ended fund is determined solely by its underlying NAV. Because there is no limit to the number of shares in an open-ended fund, as new capital comes in, additional shares are issued by the fund company after each trading day based on the closing NAV of the fund.
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Features
Because the share price of closed-end funds is determined by demand in the market, that price is often higher or lower than the value of the assets in the fund. When the price is higher, the fund is said to be trading at a premium; when the price is lower, it is trading at a discount.
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Exchange privileges
After the IPO, shares of closed-end funds generally are not redeemed by the fund. If you want to sell your shares, they must be sold to other investors on the open market. Because shares of closed-end funds are traded on the open market, they can be exchanged at any point in the trading day. Open-end funds are bought and sold through the fund company, they usually are exchanged only at the end of the trading day. If you want to invest money in an open-ended fund, the fund company simply issues more shares of the fund at that day's NAV. If you want to take some of your money out of an open-end fund, you redeem your shares through the company. Because they are not traded publicly, the price of open-end fund shares are always the same as the value of the fund's assets (NAV).
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Dividends
An attractive feature of many closed-end funds is the income they provide to investors. Investment companies are required to distribute income earned on their investments--dividends, interest, and capital gains--to shareholders. Because capital gains can be unpredictable, many closed-end funds have a managed distribution policy. That means the companies try to provide investors with a predictable stream of income. Beware: This income, paid in the form of dividends, is not guaranteed. Dividends are generally paid on a monthly or quarterly basis. The Closed-End Fund Association has compiled a directory of closed-end funds with managed distribution policies (see "Resources" below).
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Considerations
Since closed-end funds are traded on exchanges, there are usually brokerage fees and commissions associated with buying and selling the shares. You should understand what fees are involved before purchasing any shares. Funds also have very different strategies and investment objectives. Seek out this information by studying the fund's prospectus and annual reports. As with open-ended funds, a closed-end fund company charges annual management fees that are paid by reducing the NAV of the fund. The amount of those fees should be listed as part of the fund's prospectus. Remember, share prices of closed-end funds go up or down, depending on the market.
