Closed-end mutual funds are slightly different than the mutual funds most investors are used to seeing. A regular mutual fund, also known as an opened-end fund, is created by a manager to meet the needs of investors, whereas a closed-end fund (CEF) works more like stocks. It is traded on a stock exchange and is primarily used by investment companies as a means of raising capital for a company through an initial public offering (IPO). Before investing in CEFs, you should take the time to understand how they work.

What Are Closed-End Mutual Funds?

Closed-end mutual funds are an investment vehicle that has a fixed number of shares offered for sale. These types of funds are typically used by investment companies to raise capital through an IPO by issuing a fixed number of shares relative to its overall portfolio. Unlike opened-end mutual funds, the shares of a CEF are sold on the stock market and are subject to the market price rather than the net asset value (NAV). In the United States, CEFs are referred to as closed-end companies, and they form one of three SEC-recognized types of investment companies. The other two are referred to as mutual funds and unit investment trusts.

What Are Some Distinguishing Characteristics of a Closed-End Fund?

Investors can put their money in several types of funds, and each one has its own distinguishing characteristics. The CEF is most often categorized with mutual funds because it acts in the way that mutual funds were originally designed to act, although the practice of mutual funds is very different now. CEFs are traded similar to stocks on a recognized stock exchange, but there are other features that differentiate them from mutual funds. Once the shares have been put on the market for purchase, the fund becomes closed to new capital. Additionally, since the shares are traded on a stock exchange, those shares can be traded at any time during market hours. With a traditional opened-end fund, the times that can be traded are set by a manager.

How Does Leverage Work with a Closed-End Fund?

A common practice with CEFs is the use of leverage in order to increase returns. Since a closed fund cannot add capital after trading has begun, the managers of the fund have to make the most out of what is available. CEFs can raise additional capital by issuing auction rate securities, preferred stock, long-term debt, and reverse-repurchase agreements. A CEF can use a combination of these leverages, or it can use only one, which is the most common practice. The type of leverage used will depend on the stock, the market, and how much capital needs to be raised.

What is an Initial Public Offering?

Closed-end funds typically start with an IPO, which works very similar to a company moving from the private sector to the public sector. The investment company will make a certain number of shares available to the public. For example, if a company has 20 million shares and sells those shares for $20 each, the fund raises $400 million for the fund manager to invest, assuming all shares are sold. After that, those 20 million shares may be traded on a secondary market, such as the New York Stock Exchange or NASDAQ. As part of its leverage package, a CEF may choose to issue preferred stock in order to boost numbers, and this can take place after the IPO.

What Are the Advantages of Buying a Closed-End Fund over an Opened-End Fund?