1. What’s a Closed-End Fund?

There are two types of mutual funds -open-end funds and closed-end funds. Imagine they’re twins who share the same DNA but go through life doing things very differently.

Both fund types sell shares to investors and use the cash that’s invested to buy securities that match their investment missions. But that’s where the similarities end.

You may have also heard a lot about exchange-traded funds. These newly popular function similarly but they’re not mutual funds, as you’ll soon see. When people say mutual funds they’re usually referring to open-end funds. These guys can sell an unlimited number of shares to investors. The price per share-also known as the net asset value (NAV)-is calculated by dividing the market value of the fund’s assets by the number of shares held by investors.

So-if a fund has net assets of $100 million and there are 5 million fund shares in the hands of investors, the fund’s share price would be $20. That’s why open-end mutual funds trade only at the end of each day, when trading stops and the final price can be calculated.

Most people own the open-end variety in their retirement and taxable accounts.

Now let’s look at the lesser-known twin-closed-end funds. These funds issue a set number of shares that trade on the stock exchange throughout the day. The value of these shares is based on demand. If lots of investors buy shares, the price goes up. If lots of investors dump them, the price goes down.

What if a closed-end fund’s share price is lower than the fund’s net asset value? Meaning, what if the price tag on a bag of coins is less than the value of the coins inside? You’d get a discount on your investment.

The same is true for closed-end funds. If you invest in a fund with a share price that’s lower than its NAV, congratulations, you’re getting a discount. If the gap between that fund’s share price and its NAV narrows after you invest, you’ll receive a bonus when you sell shares. Just as if the price of that bag of coins went up when you sold it.

But don’t get too worked up. Most closed-end funds offer a discount. The key is how much of a discount they’re offering and whether you think the fund will perform well over time. If it does, and the discount shrinks after you’ve purchased shares then you earn a profit.

Like open-end funds, closed-end funds come in dozens of types ranging from U.S. stock and bond funds to funds that invest in a singe country or region. But don’t confuse a closed-end fund with a closed fund. A closed fund is an open-end fund that no longer accepts new investors.

Closed-end funds tend to be actively managed-meaning the manager of the fund buys and sells securities often in an effort to outperform the fund’s benchmark index. The result may be higher fees and increased taxes, if you hold the fund in a taxable account.

2. Should You Invest in a Closed-End Fund?

Let’s be honest: In recent years, closed-end funds have fallen out of favor with average investors. That’s due largely to the rise in popularity of open-end funds and exchange-traded funds (ETFs) .

To make this simple, think of an ETF as the cool cousin of the closed-end fund. ETF shares trade on the stock exchange-just like closed-end funds. But ETFs generally track a market index, making them more efficient than closed-end funds and a lot easier to understand. Most ETFs also charge lower fees and are more tax-efficient because the securities in their index-based portfolios aren’t often traded.

All that said, closed-end funds do have a few benefits:

• A closed-end fund’s discount offers you a bonus when the gap between the share price and NAV narrows after investment.
• A closed-end fund’s manager can invest without worrying that cash may be needed to meet sudden redemptions by large numbers of jittery investors, as is the case with open-end fund managers.
• Closed-end funds tend to pay investors higher levels of income because they invest more heavily in income-producing assets.

Bottom line: Unless you’re willing to roll up your sleeves and research closed-end funds and their discounts, you may be better off in a similar open-end fund or ETF.

3. How to Invest in a Closed-End Fund

Still want to invest in a closed-end fund? Follow these steps to size up a fund and get the best deal:

• Scan the horizon. Once you decide what kind of fund to add to your portfolio (U.S. stock, emerging markets, etc.), check out FiLife’s growing universe of closed-end funds or look at Morningstar’s directory here.
• Review the discount. The bigger the gap between a fund’s share price and NAV, the more likely it will narrow over time and provide you with a bonus. To evaluate the current gap, ask for the fund’s average one-year discount since its start. Then compare it to the fund’s current discount.

You can generally assume that the fund’s discount eventually will migrate back to its historical average. For example, if a fund’s historical average discount is -7% but it is now trading at a -12% discount, you can expect the fund will return to its historical 7% average-and you’ll wind up pocketing the difference.

• Size up performance. The best measure of a closed-end fund’s return is its performance over time-plus the effect on performance of the fund’s distributions. Also, the longer the fund has been in existence, with the same manager, the better. We think a fund should have at least five years of performance before you invest in it.
• Mind the debt. Beware of closed-end funds with more than 40% of debt to total assets. Such a debt level usually means the fund’s manager is using leverage to boost the income yield paid to investors, which makes the fund riskier.
• Scope your expenses. To invest in a closed-end fund, you’ll have to pay a commission on trades as well as fund expenses and high annual management fees that range from 1% to 2%. To hold costs down, look for closed-end funds with low expenses and fees, and consider trading shares through a discount brokerage.
• Check the yield. Closed-end funds tend to generate more income than open-end funds. When considering yield-producing funds, look for an annual yield that’s a couple of percentage points over that offered by U.S. Treasuries. Or look for a fund that has a discount of over 10%, unless it’s a low-risk bond fund. Just be sure the high discount isn’t the result of capital distributions or a one-time payout.
• Mind your taxes. A high percentage of closed-end funds invest in bonds and preferred stocks to provide investors with higher yields than common stocks. Remember, in taxable accounts, this yield will be taxed as income, not the lower dividend tax rate.
• Skip IPOs. Buying shares of a closed-end fund just when they’re offered through an initial public offering (IPO) comes with big risks. That’s because the fund’s discount-or gap between share price and NAV-typically widens in the months following an IPO.
• Size up the manager. See how long the fund’s manager has been in place. The longer the better if the fund has delivered above-average returns.
• Compare the fund. See how the closed-end fund you’re considering stacks up against a similar open-end or exchange-traded fund. Be sure to compare performance, fees and expenses.

4. Grilling Guide: Questions to Ask a Closed-End Fund Manager

How has the fund performed?

See how the closed-end fund has performed over the past five years or longer compared with its benchmark index-and an equivalent open-end fund.

What’s the discount gap?

What’s the fund’s historical one-year average discount and what’s its current discount? Consider funds that are more deeply discounted now than its historical average.

What’s the expense ratio?

Your returns will be based not only on performance and the discount but also how much of those returns must be shelled out for expenses and fees. Compare the average closed-end fund expense ratio with average ratios of open-end funds and exchange-traded funds investing in the same asset classes.

How often are distributions paid?