Closed-end funds are a type of mutual fund -- with a twist. Image source: Getty Images.
Most investors are familiar with mutual funds and exchange-traded funds, but closed-end funds aren't as well-known. Closed-end funds, or CEFs for short, are technically a type of mutual fund, but they combine elements of regular open-end mutual funds and ETFs. Like open-end mutual funds, closed-end funds give you a stake in a larger pool of stocks or other investments, sharing expenses with fellow shareholders. However, unlike regular mutual funds, CEFs trade directly on stock exchanges just like ETFs do, and their prices can change throughout the market day. Closed-end funds also have a fixed number of shares outstanding, which are first sold to the public in initial public offerings like stock and then subsequently offered in secondary offerings after the IPO. Because of the limits on their share counts, CEFs can trade at a premium or a discount to their net asset value, and that can be a boon for bargain-hunting value investors.
Why closed-end funds are worth a closer look
Closed-end funds traded on stock exchanges long before ETFs were even invented, with some funds going back to the late 19th century. There are several hundred closed-end funds available to U.S. investors, spanning the investment universe from stocks and bonds to commodity-driven funds. Like traditional mutual funds and ETFs, closed-end funds benefit from the fact that they don't pay any tax at the corporate level, instead passing any tax liability through to their shareholders.
Yet the most interesting aspect of closed-end funds is how the market price for their shares can differ from the underlying value of the assets inside the fund. With most mutual funds, you have an opportunity to buy or sell at the fund's net asset value on a daily basis. However, because CEFs don't issue new shares, market supply and demand determine pricing on a short-term basis. If a closed-end fund gets popular, then its shares often trade at a premium, meaning that the share price in the market is higher than the value per share of the fund's investments. By contrast, CEFs that are out of favor often trade at a discount to NAV, offering value investors a bargain.
Things to keep in mind with closed-end funds
There are some downsides to closed-end funds. First, share prices can fluctuate dramatically, and that can cause unforeseen losses. For instance, if your fund goes from a premium to NAV to a loss, then your stock can lose value even if the underlying investments within the fund stay stable or even rise. That comes as a shock to many first-time CEF investors.
Also be careful to look at the expenses of closed-end funds. Many CEFs have relatively high expense ratios, and the fact that they have a captive audience of shareholders allows them to collect those fees on an ongoing basis. In fact, some believe the reason why many CEFs trade at a discount is because of the high fees that many charge.
Even with those caveats, closed-end funds can be a great way to diversify your overall portfolio. Although they're more complicated than a simple mutual fund, closed-ends can offer opportunities you won't find anywhere else in the investment world.
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