- Closed-end funds generally do not raise new capital from investors or otherwise issue new shares. They are "closed" to new equity investments. Open-end funds (ETFs and mutual funds) constantly accept new investors and cash out selling investors.
- Since no new capital is coming in and most of its capital gains and net income are distributed back to investors, Closed-end funds often use debt to raise additional funds used to -- or attempt to -- boost returns.
There are other differences, but these are some of the key ones. One more that's very important to investing in closed-end funds is understanding how their shares are priced.
Unlike ETFs and mutual fund shares, which tend to trade very closely to the net asset value of the assets owned by the fund, closed-end funds can trade for a wide range of prices, including a significant discount or significant premium to NAV.
This is the case for a few reasons. As a starting point, the use of debt can play a role. A fund that successfully uses debt leverage to boost returns will generally trade for a premium, especially if the manager has a track record of delivering outsized gains.
Simply put, the effective use of leverage adds value above the NAV. This can also be the case if the fund invests in a sector or area that's popular with investors. On the contrary, if a sector is out of favor and a closed-end fund has significant exposure to it, it may trade for a discount to NAV even if the assets owned by the fund are high-quality.
Lastly, the simple math of supply and demand can play a role as well. Unlike open-end funds that issue new shares when demand increases and buy back shares when demand weakens -- keeping their price more in line with NAV -- the fixed, limited supply of shares in a closed-end fund can further disconnect from NAV simply based on whether investor demand is high or low.
The risks of investing in closed-end funds
Like all investments, closed-end funds come with risk. Here are a few specifics to consider:
- Leverage risk: The use of debt to boost returns can also amplify losses.
- Derivatives risk: Trading in derivative instruments (such as for debt and commodities) comes with volatility that can result in significant losses.
- Concentration risk: Closed-end funds typically focus on a region or asset class. This can boost returns but also amplify losses.
- Credit risk: Owning debt can pay off, but if the payee defaults, losses can result or take years to recover.
There are more risks, but these are some of the most important to consider.
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