Most investors are familiar with mutual funds and exchange-traded funds (ETFs), but fewer are familiar with closed-end funds.
Despite being older than both mutual funds and ETFs, closed-end funds (CEFs) offer some distinct advantages for long-term investors who want to diversify their holdings.
Despite their name, CEFs are always open to new investors, even after the fund has started to trade. “Closed-end funds” derived that name because they offer a finite number of shares, so the amount of shares is limited or closed. As a result, a CEF does not continuously offer new shares. When a new investor wants to buy into the CEF, they will see a continuous bid and offer throughout the trading day based on the current market price of the CEF’s holdings. Since the CEF has a limited number of shares, its price is based on market demand.
In contrast, the price of a mutual fund is based on the net asset value (NAV) of its holding as determined at the end of the trading day. Another major difference between mutual funds and closed-end funds is that mutual funds can continuously offer new shares to new investors. In theory, a mutual fund can continuously grow to accommodate new investors. CEFs can not since they only offer a finite number of shares.
Aside from how their share price is determined, CEFs and mutual funds have many similar features: CEFs can invest in bonds, real estate, growth, small cap, value and international stocks. They also can use leverage, so some closed-end funds invest in real estate and other assets which require the use of borrowed money. Investors also buy into the CEF at par, so subsequent prices can go lower or higher.
Closed-end funds differ from exchange-traded funds because they provide active management, as opposed to the indexes that underlie ETFs.
One of the Oldest Fund Investments
There are about 750 CEFs offered, according to Brian M. Smith, director of the Closed-End Fund Association in Kansas City, Mo. Some of the oldest CEFs – General American Investors (NYSE: GAM), Adams Express Company (NYSE: ADX), Tri Continental (NYSE: TY) — started in 1929, Smith said. That was well before the introduction of mutual funds, which trace their origins to the Investment Company Act of 1940. CEFs also are more heavily regulated than mutual funds, Smith said, since they are registered both as corporations and mutual funds. Today, many of the same large companies that offer mutual funds — Royce Funds, Gabelli Funds, Nuveen , BlackRock — also use their investment expertise to offer CEFs.
Risks and Rewards of Closed-End Funds
CEFs are usually appropriate for people seeking income, and for investors “looking for the opportunity of greater return, who can also assume greater risk,” Smith said.
Since CEFs can invest in leveraged investments, such as non-liquid assets like a shopping center, and trade at a market value, they often trade at a discount, Smith explained. When this occurs, the average closed-end fund can be sold for less than the value of the assets it already owns. As the CEFs discount narrows, it creates greater returns for its investors.
Investors who purchase CEFs pay commissions which are no different than those in the mutual fund industry, Smith said. They can be bought at a discount from a broker-dealer, discount broker, financial adviser or as part of an auto-direct investment program,
Since CEFs can invest in leveraged assets, they are typically not offered in 401(k) plans, Smith said.
Disclosure I am long 18 closed end funds none of which are mentioned here.
My favorite Closed end fund research site is CEF CONNECT.
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