Closed-end funds are an oft-overlooked investment choice and never seem to get the attention lavished on exchange-traded funds (ETFs) or open-ended (mutual) funds. They come in many different varieties and can serve many different investment objectives. While they may not be for everyone, it is important to understand what closed-end funds are, how they operate, and the potential opportunities they may present to you as an investor.
What are closed-end funds?
A closed-end fund is a publicly traded investment company and is legally defined as a closed-end company. Similar to a publicly traded company, they can raise capital through an initial public offering (IPO) and trade on an exchange like a stock with a ticker symbol. Closed-end funds issue a fixed number of shares and usually hold a portfolio with a particular focus or specialty with active management (managed by a fund manager) as opposed to having broad market exposure like a passive investment.
To better understand closed-end funds, it is helpful to compare them against mutual funds. While both are subject to similar SEC regulations when it comes to investor protections, there are a few structural differences. Mutual funds, also known as open-ended funds, are another type of investment company that does not have a fixed limit of shares it issues to the public and can issue more shares after an IPO. In contrast, closed-end funds will not issue additional shares after its IPO. Closed-end funds are determined by the market price through trading activity on an exchange. Open-ended funds are determined by the net asset value (NAV), which is calculated once at the end of every trading day. Shares of an open-end fund are redeemed through the fund itself and not through an exchange.
Some examples of closed-end funds include the New Ireland Fund (IRL), which is a mid-cap growth oriented fund that focuses on the investment in Irish companies that operate in the technology, healthcare, and telecommunications sectors. PIMCO CA Municipal Income II (PCK 0.35%) is a fund that invests primarily in municipal bonds and pays interest on a monthly basis. Nuveen NASDAQ 100 Dynamic Overwrite (QQQX 0.71%) is a fund that tracks the performance of the Nasdaq 100 Index, but does so with less volatility. QQQX is able to do this through the use of call options -- investment vehicles that provide you with the option to buy a security at a particular price in the future without have to purchase it outright. This is often used as a risk management tool and a way to hedge one's bets to avoid any downside.
Advantages
Closed-end funds can offer investors access to a low-cost form of professional portfolio management. When it comes to fixed income, closed-end funds can be attractive to investors looking for a stream of income that occurs more frequently than the typical semi-annual interest payouts of bonds. For instance, a closed-end fund can be structured to provide fixed-income exposure with payouts made on a monthly basis. These types of funds can utilize leverage, and given the right application, may be a plus for those investors with a higher risk tolerance. Given that closed-end funds issue a fixed amount of shares only one time, they do not have the costs of redeeming and issuing further shares. These are the costs you would normally see with mutual funds which can make closed-end funds a more advantageous investment option compared to other types of funds with similar investment strategies.
Potential disadvantages
In general, closed-end funds are less liquid than open-ended funds or ETFs and can be more volatile. The share market price can deviate from the value of the underlying assets, which is calculated by the NAV. However, this can provide an opportunity for those looking to exploit this discrepancy, either when the price per share trades at a premium (above NAV) or at a discount (below NAV). Closed-end funds also use debt in the form of leverage in their investment activities. While this can provide positive opportunities in bull markets, debt can also increase a fund's volatility and potentially magnify a market's downturn. Because closed-end funds account for a smaller share of the market compared to stocks, bonds, ETFs, and mutual funds, trading volumes can be thin. This is another reason for a possible increase in volatility.
Whether or not you should invest in a closed-end fund depends on your objective. If you are looking to obtain exposure in a niche market, and appropriate due diligence is carried out, then these funds might be worth considering. If, on the other hand, you are looking for broad market exposure that does not necessitate active management, then a low-cost mutual fund or an ETF might be a more appropriate direction.
