The Mystery of Closed-End Funds

To most investors, closed-end funds have been the red-headed stepchild of the investment world. Few people pay attention to these funds, and even fewer understand exactly what they are. However, as a recent Wall Street Journal article highlighted, closed-end funds have been on fire so far this year. Billions of dollars have found their way into these funds in the first few months of the year, and many fund companies are planning huge IPOs of closed-end funds in the coming months.

Now, anytime something starts getting touted as "the next big thing," it's always Foolish to stop and take a critical look before you hop on the investment bandwagon. In the case of closed-end funds, what's behind all the hype?

Back to basics
First, a little refresher. Open-end funds, the more familiar form of mutual funds, allow investors to buy or sell shares at the fund's net asset value (NAV) directly from the fund company. When someone wants to buy, new shares in the fund are issued; conversely, when someone wants to cash out, the shares are sold back to the fund company. In contrast, closed-end funds have a limited number of shares and generally do not redeem or issue shares. When investors want to buy or sell their shares, they must go to the secondary market and find other investors who want to trade their shares. This means that closed-end funds are essentially closed to new capital after the initial offering of its shares. Thus, managers don't have to accommodate any inflows or redemptions.

And while a closed-end fund can hold the same shares that open-end mutual funds do, shares of the closed-end fund can be traded at any time during the trading day. Open-end funds' shares, in contrast, can be traded only at the closing price at the end of trading on that particular day.

Open-minded about closed-end funds
One of the more puzzling things about closed-end funds is that they often sell at a discount (or, less frequently, a premium) to net asset value. Unlike open-end funds, which always trade at their stated NAV, most closed-end funds have historically traded at something less than NAV. How can this be? Well, truthfully it's just always been that way, and even the smarty-pants Wall Street types haven't been able to figure out exactly why. Just know that when dealing with closed-end funds, this is almost always the case.

So why are these oft-forgotten funds suddenly experiencing a surge of popularity? While part of the story may be a renewed interest in the higher yields that many of these funds tend to offer, a bigger part probably has to do with exchange-traded funds. ETFs have been one of the fastest-growing investment vehicles in recent memory. Again, part of their appeal stems from investors' ability to trade ETFs throughout the trading day. Closed-end funds share this flexibility, and they're likely catching the tailwind of popularity that ETFs have created. I'm guessing that without all the industry focus on ETFs, interest in closed-end funds would not have been booming the way it has in recent months.

Caution ahead
As skeptical Fools know, anytime your hear something being described as a boom, two more words should immediately come to mind: "bubble" and "bust." As much as we would all like to think the market is simply an aggregator of rational information and prices, we are all aware that at times, the market is prone to excess and speculation. And as quickly as people rush into one stock, one sector, or one investment product, they can just as quickly rush back out, leaving you holding the bag. I'm not implying that's necessarily what's happening now with closed-end funds, but I am saying that if you're thinking of getting into closed-end funds, don't do so because you think that everyone else is doing it, too.

Approach buying a closed-end fund the same way you would approach buying an open-end fund. Ask yourself: Does this fund make sense in the context of my overall portfolio? How long has the fund been around? What about the management team and expenses? In the case of closed-end funds, look at the current discount at which the fund is trading in relation to where it has traded in the past. And don't ever buy a closed-end fund at a premium! If you do venture into this overlooked area of the market, make sure you do your own research and buy funds that are an appropriate fit for you. Undoubtedly, there are some good bargains to be had in the land of closed-end funds -- just take the scenic route to get there, not the express.

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Closed-end or open-end, load or no-load, you can count on the Fool's Champion Funds newsletter for helpful tips on the best funds for your portfolio. Fool fund expert Shannon Zimmerman finds promising funds each month that have outperformed their peers through good times and bad. Get your free 30-day trial today, and starting learning about the best mutual funds you can buy.

Fool contributor Amanda Kish lives in Rochester, N.Y., and is convinced that if she can still hear the grinding noise made by her car, that means the radio isn't loud enough. Amanda does not own shares of any of the companies or funds mentioned herein. The Fool has a disclosure policy.


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