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The Mystery of Closed-End Funds

Amanda B. Kish, CFA
April 12, 2007

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