When it comes to mutual funds most investors put their money into what are known as open-end funds. An open-end fund allows unrestricted inflows of new investor money as well as redemptions and thus has a constantly changing amount of assets under management. An open-end fund with superior returns will generally increase in size as investors pour money into it. By contrast a closed-end fund maintains a fixed amount of money under management which results in both advantages and pitfalls for investors in the fund. Keep reading to learn more about closed-end funds to decide if they should be a part of your investment portfolio.

What Is a Closed-End Fund?

A closed-end fund raises money through an initial public offering by selling a fixed amount of shares to investors. The fund does not accept new money from investors nor does it allow fund redemptions. The initial amount of money raised by a closed-end fund stays in the fund and is invested by the fund managers based on their specific investment goals.

How Can I Buy or Sell Shares in a Closed-End Fund?

Closed-end funds trade throughout the day on a stock exchange. An investor that purchased shares at either the initial public offering or at a later date can simply put in a sell order just as with any other stock or mutual fund. An investor seeking to purchase shares in a closed-end fund places an order with his broker and the purchase is easily done. Regardless of the amount of shares bought or sold by investors in a closed-end fund, total assets held by the fund will change only due to market fluctuations of securities held by the fund. Buyers and sellers are directly exchanging shares through their brokers with no impact on the amount of funds held by the closed-end fund.

Why Do Closed-End Funds Trade at Discounts or Premiums to Net Asset Value?

Open-end mutual funds or an exchange traded funds (ETF) are typically purchased at the net asset value (NAV) of the fund which is determined by dividing the value of all securities held by the number shares outstanding. Investors are able to sell at the net asset value since they are selling their shares back to the investment fund company. In the case of a closed-end fund an investor is not able to sell shares back to the fund company but instead sells them on the open market to another investor at the going market price which may be more or less than the NAV. For example, a closed-end fund that invests in municipal bonds may sell at a steep discount during a period of panic over concern about potential defaults in the municipal debt market. It is quite common to see closed-end funds trade at either a discount or premium to NAV.

What Are the Advantages of a Closed-End Fund?

The managers of a closed-end fund do not have to worry about constant inflows and outflows of investor money. This is especially important during periods of market stress especially if the fund holds leveraged positions. Large redemption demands in an open-end fund could force managers to liquidate positions at low prices during market panics. This situation could be especially disruptive if a fund uses leverage since the declining values of assets held in the fund could result in further forced liquidations as lenders to the leveraged fund call in loans due to inadequate collateral value caused by plunging prices.

During market panics the discounts on closed-end stock funds can become quite large allowing a long term investor to purchase shares at steep discounts to the underlying NAV of the fund. As markets eventually recover and the discount to NAV narrows an investor would capture capital gains. An investor purchasing a closed-end bond fund at a steep discount would enjoy a higher interest yield than by purchasing a similar basket of bonds that sold at NAV through an open-end fund.

What Are the Disadvantages of a Closed-End Fund?