Closed-End Funds: Investing Essentials

Find out what you need to know about closed-end funds.

Jul 31, 2014 at 2:15PM

Adx Pic Library Of Congress
Picture taken in front of the offices of major closed-end fund Adams Express. Source: Library of Congress.

Ask most investors what closed-end funds are, and you'll probably get a lot of blank stares. Yet even though closed-end funds aren't the most well-known investments available, they have some true advantages over other types of investments that can work in your favor.

Most investors know that mutual funds and exchange-traded funds both offer opportunities for investors to diversify their portfolios even if they only have modest amounts to invest. Closed-end funds share many of the advantages of ETFs and mutual funds, but they also have unique attributes that can be attractive to many investors.

What are closed-end funds?

Closed-end funds are like mutual funds and ETFs in that they are pools of investments in which shareholders each own a small fraction of the overall fund. Most closed-end funds specialize in certain categories of investments, so you can find funds geared toward domestic or foreign stocks as well as fixed-income investments of different varieties. Other closed-end funds use more sophisticated tactics, such as covered-call options techniques, to generate more income.

Cef Me

Source: Author.

Closed-end funds trade on stock exchanges just like ETFs do, giving investors the chance to buy or sell at any point during the market day, as opposed to the once-daily trading and pricing of traditional mutual funds. What makes closed-end funds different from ETFs and mutual funds, though, is that closed-end funds only have a fixed number of outstanding shares. As a result, prices of closed-end funds don't always track the underlying value of the investments they hold, which means their shares often trade at premiums or discounts compared to their net asset value.

What is the history of closed-end funds?

Closed-end funds are much older than ETFs, having served the purpose of providing instant liquidity for decades before the explosion in ETF popularity. Closed-end funds have been around for more than a century, with the first fund coming into existence in 1893. But the Investment Company Act of 1940 helped to popularize closed-end funds as well as traditional mutual funds, as it created a way for fund managers to set up funds that would comply with regulatory requirements. In addition, favorable tax laws that eliminate double taxation and allow closed-end funds to pass taxable income on to their shareholders made closed-end funds more attractive as investments for ordinary investors.

How many closed-end funds are there?

According to figures compiled by Aberdeen Asset Management, a major closed-end fund provider, there are more than 600 U.S. closed-end funds available in the market today. Although many funds are relatively new and have limited track records, you can find others with decades-long track records.

Why invest in closed-end funds?

Closed-end funds make useful investments for several reasons. Unlike most ETFs, closed-end funds typically have actively managed portfolios, rather than passively tracking an index. That makes closed-end funds more expensive than many ETFs when it comes to expense ratios and other management costs, but many investors believe the dynamic portfolios that closed-end funds offer are worth the additional cost.

Closed-end funds also offer exposure to underlying assets that other investments don't. For instance, it can be difficult to find options-oriented investments outside the closed-end realm.

What really makes closed-end funds stand out from other investments, though, is the opportunity to get funds' shares at a discount to the value of their underlying assets. With some closed-end funds, investors are willing to pay premiums above their net asset value, often because it's difficult to buy the underlying assets directly. For asset classes that are more out of favor, discounts typically predominate. Yet in just about every case, closed-end fund shares will see greater discounts at certain times and smaller discounts or even premiums at other times.

Buying closed-end funds when their shares are particularly cheap compared to their net asset value gives you the opportunity to boost your total returns. Often, the underlying assets will rise in value at the same time that the discount narrows or turns to a premium. Therefore closed-end fund investors will get outsize returns, because the narrowing discount will provide even greater gains on top of the appreciation in the fund's holdings.

Similarly, buying closed-end funds at a premium can be dangerous. If the underlying assets fall in value, and the premium turns to a discount, shareholders can suffer much larger losses than they would if they used other investment vehicles to buy those assets.

Overall, closed-end funds are an excellent tool that smart investors can use to broaden their investing horizons and gain opportunities that others miss. Their quirks can take some getting used to, but it's still smart to investigate closed-end funds and see whether they deserve a place in your portfolio.

Dan Caplinger owns shares of Adams Express Company. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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